Second, a rise in deflationary expectations produces an equivalent rise in real interest rates. Typically, nominal interest rates would be reduced to counteract this rise in real interest rates, but when an economy comes up against the zero bound on nominal interest rates, it is possible for real interest rates to rise above their optimal level and thus depress economic activity.
Moreover, the persistently deflationary international environment, the gradual pace of increases in U.S. resource utilization, the estimated small effect of resource utilization on inflation, the likely low level of neutral interest rates, and the persistence of inflation below our 2 percent target suggests this risk remains modest. Financial markets appear to agree, as five-year inflation compensation is well below 2 percent.