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In this paper the author discusses the possibility that the U.S. economy may become enmeshed in a Japanese-style deflationary outcome within the next several years. To frame the discussion, the author relies on an analysis that emphasizes two possible long-run steady states for the economy: one that is consistent with monetary policy as it has typically been implemented in the United States in recent years and one that is consistent with the low nominal interest rate, deflationary regime observed in Japan during the same period. The data considered seem to be quite consistent with the two steady-state possibilities. The author describes and critiques seven stories that are told in monetary policy circles regarding this analysis and emphasizes two main conclusions: (i) The Federal Open Market Committee's "extended period" language may be increasing the probability of a Japanese-style outcome for the United States and (ii), on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.
(JEL E4, E5)
Federal Reserve Bank of St. Louis Review, September/October 2010, 92(5), pp. 339-52.
THE PERIL
In 2001, three academic economists published a paper entitled "The Perils of Taylor Rules."1 The paper has vexed policymakers and academics alike, as it identified an important and very practical problem - a períl - facing monetary policymakers, but provided little in the way of simple resolution. The analysis appears to apply equally well to a variety of macroeconomic frameworks, not just to those in one particular camp or another, so that the peril result has great generality. And, most worrisome, current monetary policies in the United States (and possibly Europe as well) appear to be poised to head straight toward the problematic outcome described in the paper.
The authors of the 2001 paper - Jess Benhabib at New York University and Stephanie SchmittGrohé and Martin Uribe both now at Columbia University - studied abstract economies in which the monetary policymaker follows an active Taylor- type monetary policy rule - that is, the policymaker changes nominal interest rates more than one for one when inflation deviates from a given target. Active Taylor-type rules are so commonplace in present-day monetary policy discussions that they have ceased to be controversial. Benhabib, Schmitt-Grohé, and Uribe also emphasized the zero bound...