Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures. Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008 – a time when the economy was contracting sharply.
At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament.