By Nick Timiraos 

The success of the Federal Reserve and other central banks in reducing inflation and holding it at low levels has limited the scope for monetary policy to combat future downturns, a top Fed official said in a speech set for delivery Tuesday.

Fed Vice Chairman Richard Clarida highlighted how both lower global bond yields and the successful response of the U.S. central bank to combat the high inflation spells of the 1970s and early 1980s have laid the groundwork for new challenges.

"These two phenomena, taken together, have resulted in sovereign bond yields that are substantially lower than the precrisis experience, and thus substantially closer to the effective lower bound for the policy rate than they were before the crisis," said Mr. Clarida in remarks prepared for a policy conference in Zurich.

Mr. Clarida's speech draws attention to a range of factors that have pulled down long-term global bond yields, including the decline not only in inflation but in the volatility of inflation.

The Fed has typically cut its benchmark interest rate by more than 5 percentage points in recent downturns. But with officials unlikely to cut rates below zero, they will have less room to reduce rates to stimulate growth with their conventional tools in a future downturn.

The Fed added to its tool kit after the 2008 financial crisis, but Mr. Clarida's speech highlights potential limitations of these tools going forward.

After cutting rates to near zero in 2008 during the financial crisis, the Fed conducted rounds of bond purchases over five years to further stimulate growth. The central bank lowered long-term rates and encouraged investors to purchase riskier assets, such as corporate bonds, stocks and real estate.

Today, rates remain lower than before the crisis, limiting how much the Fed and other central banks can stimulate growth by pushing down long-term yields.

Following the last two recessions, for example, yields on the benchmark 10-year U.S. Treasury yield declined by roughly 3.6 percentage points and 3.9 percentage points, respectively. "I will confess that I think it highly unlikely in the next downturn, whenever it is, that 10-year U.S. Treasury yields will fall by the roughly" similar magnitudes, Mr. Clarida said.

The reality of lower global interest rates and bond yields has been a motivating factor behind the Fed's review of its policy framework, said Mr. Clarida. While many households may not see low inflation as an undesirable outcome, it is a concern for the Fed because a down-drift in inflation will also reduce nominal interest rates, leaving less room to stimulate growth during and after a downturn.

When central banks were first setting inflation targets in the 1990s, they were worried about inflation running too high and sought to establish expectations -- for both business and consumers -- that future inflation would be tame. Behind this approach was the belief that expectations play an important role driving actual inflation.

The Fed formally adopted a 2% inflation target in 2012. Under the framework, it doesn't take into account what happened the year before -- a "let- bygones-be-bygones" approach. Inflation has only reached the target during a few months in 2018. It has held below the target most of the time, raising concerns that inflation expectations might drift lower.

As part of policy makers' review, Fed officials in September examined approaches to allow for a "makeup" of past inflation misses -- ending the "bygones" policy -- to help firm up inflation expectations.

Mr. Clarida said the benefit of such an approach depended critically, however, on the private sector's understanding the new policy as well as the expectation that different Fed officials would follow through on those promises.

"An advantage of our current framework over makeup approaches is that it has provided the committee with the flexibility to assess a broad range of factors and information," Mr. Clarida added.

The Fed is set to conclude its policy review and announce any changes in the middle of next year, Chairman Jerome Powell said at a press conference last month.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

November 12, 2019 05:44 ET (10:44 GMT)

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