Comments on Francisco J. Ruge-Murcia’s“The Zero Lower Bound on Interest Rates and Monetary Policy in Canada” Bank of Canada Economic Conference “Issues in Inflation Targeting” April 28-29, 2005 Peter N. Ireland Boston College and NBER
This paper skillfully constructs, estimates, and analyzes a model of the term structure of interest rates that explicitly accounts for the zero lower bound (ZLB) on the short-term rate. • The intuition: Use longer-term rates to draw inferences about the likelihood that the short-term interest rate will bump up against the ZLB at some point in the future.
The result: The ZLB has not played a big role in shaping term structure dynamics in Canada. • Implication for term-structure modelers: Linear models that abstract from the ZLB suffice for describing the Canadian data. • Implication for monetary policymakers: Good news for the Bank of Canada … • … and possibly for other inflation-targeting central banks as well.
Canada and Japan • A companion paper, Ruge-Murcia (2002), finds that the ZLB has mattered for the term structure in Japan. • The comparison between Canada and Japan highlights a number of more general issues.
Consider a Taylor rule: R = R* + a(Y−Y*) + b(Π−Π*) • There is a trade-off in setting the inflation target Π*: • Setting Π* too high imposes welfare costs of inflation … • … but setting Π* too low risks bumping up against the ZLB.
The Bank of Japan’s choice of Π* = 0 is probably too low … • … but the Bank of Canada’s choice of Π* = 2 seems about right. • Hence, it appears that the trade-off involved in choosing Π* can be managed satisfactorily.
Also, Japan has not adopted an official inflation targeting strategy. • Does inflation targeting reduce the problems associated with the ZLB? • It would be useful to extend the analysis to a larger sample of countries to find out.
Persistence in the Short-Term Rate • For Canada: rstart = 0.977rt-1− 0.053rt-2 + 0.074rt-3 • For Japan: rstart = 0.598rt-1+ 0.127rt-2 + 0.214rt-3 • Largest root: 0.9982 for Canada and 0.9615 for Japan.
What role does persistence in the short-term rate play in avoiding the ZLB? • Adding persistence seems to have been the preferred solution in the US.
Adding More Structure to the Model • An important intermediate result: the volatility, as well as the level, of the short-term interest rate matters. • But, from a central banker’s perspective, the level and volatility of the short-term rate can both be influenced by policy.
Elaborating on the model by describing the dynamics of short-term rates using a Taylor rule instead of a pure time series model … • … and by thinking hard about the fundamental sources of volatility in short-term rates … • … would be quite useful in teasing out additional policy implications.
The Benefits of Inflation Targeting • When adopting the Taylor rule R = R* + a(Y−Y*) + b(Π−Π*) the central bank chooses Π* as well as a and b. • Every central bank has an inflation target! • The only question is whether and how to communicate information about Π* to the public.
Providing more explicit information about Π* can potentially help … • ... partly by minimizing the problem of inflation scares (keeping interest rates low) … • … but perhaps also by minimizing the problems associated with the ZLB (but not too low). • Francisco’s paper contributes importantly to the debate by highlighting the second set of issues.