This was Miles Kimball’ contention, questioned by David Andolfatto recently. An anecdote from the sticky price DSGE literature. Suppose we take the view that the Great Recession was primarily a credit crunch. As such, looser policy would have been a very weak instrument to offset it. In the New Keynesian framework modified to include credit frictions, a credit crunch causes actual output to fall, but also the natural rate of output consistent with flexible prices. A monetary expansion afforded by negative nominal rates would boost aggregate demand, net worth, and lower spreads, counteracting the credit crunch, but at the expense of prohibitively high inflation.
In that same framework, where the microfoundations enable us to figure out what the best policy would be, it would be actually extremely costly to try to entirely offset the effect of the credit crunch on output. By the same token, the same logic would suggest that conventional aggregate demand-boosting fiscal policy would not do the job either, since in this framework such policy works through the same output-gap inflation-boosting channel.
Even if you buy the basic set up of the model, (ie, sidestepping all the conversations about macro wars and microfoundations), how much weight you place on this prescription depends on weighing up a few things.
For starters, the result depends on the model encoding very high costs of inflation. These come about because it’s assumed that demand for a firms’ goods, which has to be satisfied no matter what, is very sensitive to a relative price misalignment caused by not being able to adjust prices for higher inflation. This causes firm production and hours worked to be volatile, and this volatility hurts the consumer-worker-firm-owners.
That said, the model excludes a couple of things that may understate the cost of deviations of inflation from target. i) it doesn’t model money seriously, and doing so seems often to make inflation more costly. ii) it assumes rational expectations and full commitment to the inflation target. In reality, it would be fair to assume that there would be doubt about the authorities’ commitment to that target. That would dispose a policy maker to be reluctant to let inflation wander a long way from target in pursuit of reversing a credit crunch, for fear of incurring large costs of disinflation down the road.
This isn’t to say that these models suggest that what the Fed did was wrong. On the contrary, you could use them to explain why the Fed cut rates as aggressively as they did. Note that inflation hasn’t wandered all that much from target throughout, in the US.
Much more effective at increasing output, and therefore much more desirable, in these models, would be policies that attack the credit crunch at source and substitute the reduced capacity for the private sector to intermediate and bear risk for the deeper pockets of the public sector: capital injections into banks; subsidies for private lending; asset purchases. The Fed and HMT/BoE did just this. Still we had a credit crunch and a Great Recession. One inference is that the authorities did too little counter-credit-crunching of this sort. Or it could indicate that in reality the credit policies have costs not encoded in the model. Or of course the models may be off for any number of other reasons.
I would agree with Miles that it would be useful to have negative nominal rates to eliminate the risk of losing control of inflation on the downside, and being stuck in a liquidity trap. In fact, we might even be on our way there now. But that didn’t happen during the Great Recession period in question. (Perhaps fortuitously). And through the lens of these models it would not have been effective or desirable as a tool to counter it.