C OMMUNICATION POLICIES

When discussing easiness or tightness of monetary policy, one should remember the distinction between real and nominal interest rates discussed in section 2.4. Even when nominal interest rates are zero, the real interest rate may be high due to deflationary conditions.

Further on, it is generally argued that it is not the short term interest rates but rather long term interest rates and yields that are of importance to investment and borrowing decisions.

Also, pricing of long-lived financial assets, such as equities and mortgages, depends on both the current short term interest rate, as well as the entire future path for the short term interest

rates. This is often referred to as the term structure of interest rates. Financial conditions, which play a crucial role in the monetary transmission mechanism, thus depend on the on the entire expected future path of short term interest rates (Bernanke et al. 2004).

Central banks have little direct control over long term interest rates. However, they can indirectly influence long term interest rates and yields on various financial assets by communication. By actively trying to shape the public‟s expectation about the future path for short term interest rates central banks may to some extent gain control over longer term interest rates. Eggertson and Woodford (2003) argue in context of their general equilibrium model, that when the zero nominal bound is hit, this is essentially the only policy tool central bankers have at their disposition. Even though the short term nominal interest rate is zero, additional stimulus can be provided by committing to a low interest rate policy over a longer term than previously expected. A credible commitment to a low interest rate policy should in turn lower yields throughout the term structure and support investment activity and asset prices.

How can monetary authorities commit to low interest rate policy in a matter that is perceived as credible by the public? Bernanke and Reinhart (2004) discuss that a commitments to low interest rate policy in the future can be done unconditionally or conditionally. Unconditional commitment means that a central bank pledges to hold the short term nominal interest rates low for a given period of time, for example a calendar year. A conditional commitment does not link the policy to a fixed period of time, but rather to economic conditions. A central bank may pledge to hold the short term interest rate low until sustained economic growth or some other measurable effect is observed. As economic conditions can change rapidly, central bankers have traditionally applied conditional commitment in the conduct of monetary policy.

Alternatively, Clouse et al. (2000) suggest that central banks could commit credibly to a low interest rate policy by issuing options. Such options would have an upper ceiling for the nominal short term interest rate, and if interest rate rose beyond this limit at expiration date, purchasers of these options would profit at the expense of the central bank. Bernanke (2002) proposes similarly, that a central bank can announce a low interest rate ceiling for government bonds up to a certain maturity, and then commit to buy an unlimited volume of

those bonds. This can directly depress the long term interest rates, though, in theory the central bank may end up buying the whole existing stock of bonds.

Eggertson and Woodford (2003) emphasize the importance of a central bank committing in advance to a policy rule, such as the Taylor rule. The problem is, however, to design a rule that can be applied both in normal conditions as well as when there is a risk for hitting the zero nominal bound.

Central banks have become more predictable the recent years, reflecting factors like increased transparency and perhaps an explicit policy framework such as inflation targeting.

In addition, central banks actively communicate their view on the outlook for the economy and the implications for monetary policy. Bernanke et al. (2004) suggest that importance of central banks‟ communication may be elevated in times when nominal interest rates are zero or close to zero. Similarly, the importance of transparency in the conduct of monetary policy might be heightened in such circumstances, as public understanding of the central bank‟s actions can have significant implications for policy effectiveness.

Krugman et al. (1998) argue that the optimal way to escape from a liquidity trap is to generate expectations of a higher future price level and thereby expectations of higher than normal future inflation. Svensson (2003) argues in a similar fashion that price level expectations are the real problem in a liquidity trap, not expectations about future short term interest rate level per se. Even though the central bank may be able to depress long term nominal rates by communication policies, low inflation expectations may cause the real interest rate to be too high to stimulate the economy. Hence, Svensson suggests that in a liquidity trap when zero lower bound is strictly binding, central banks should induce the private sector to expect a higher price level in the future. This will reduce the real rate of interest even though the nominal rate of interest is unchanged. In assessing policy alternatives, the focus should be on how effective different policy alternatives are on affecting expectations about the future price level.

In contrast to Krugman et al. (1998), Svensson (2003) provides practical advice on how policymakers can induce the private sector to expect higher price level in the future. As mentioned earlier, any nominal quantity could serve as a nominal anchor for the economy.

Svensson (2003) suggests that when zero lower bound is binding, monetary authorities could

apply the nominal exchange rate as an alternative target or instrument for the central bank.

He argues that “the foolproof way” to escape from a liquidity trap involves, first, an announcement and implementation of a price level target. Second, a depreciation of the currency and a peg consistent with the price level target. Third, an exit strategy should be in place when the price level target has been reached. The idea behind this is precisely to influence the private sector‟s expectation about the future price level, so that the real interest rate falls and economy expands out of the liquidity trap.