The Deflationary Bias of the ZLB and the FED's Strategic Response

Abstract

The paper shows, in a simple analytical framework, the existence of a deflationary bias in an economy with a discretionary Central Bank, low natural rate of interest and a Zero Lower Bound (ZLB): the presence of the ZLB prevents the central bank from offsetting negative shocks to inflation which pushes average inflation below the target; this drags down inflation expectations and reinforces the likelihood of hitting the ZLB. We show that this deflationary bias is particularly relevant for a Central Bank with a symmetric dual mandate (i.e. minimizing deviations from inflation and employment), especially when facing demand shocks. But a strict inflation targeter cannot escape the sub-optimal deflationary equilibrium either. The deflationary bias can be mitigated by targeting "shortfalls" instead of "deviations" from maximum employment and/or using a flexible average inflation targeting. However, changing monetary policy strategy risks inflation expectations becoming entrenched above the target if the natural interest rate increases.