Immediately upon reaching the zero bound, we provided additional stimulus by expanding our balance sheet and deploying forward guidance on the policy rate. These actions, in the context of a strong commitment to both our inflation and employment mandates, succeeded in preventing deflation expectations from taking hold, even though real outcomes were disappointing. We also took steps to formalize our 2 percent inflation objective.7 The Fed’s large-scale asset purchase programs differed from those originally undertaken in Japan both in theory and in practice. They were concentrated in longer-term securities – Treasuries and agency mortgage-backed securities. This reflected a different perspective on how purchases affect financial conditions and the economy, as well as the different structure of our financial system. Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand. The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct – not the goal – of these actions. The U.S. also moved relatively quickly to recapitalize core financial institutions – partly as a result of good judgment, but also because the intense pressures of a capital markets-based financial system forced us to confront these issues.
The evolution of policy in Japan, in turn, has been informed, in part, by the experience of the U.S. and other nations. So what have we learned to date? Let me highlight six key points. First, and most importantly, managing expectations is critical in the execution of monetary policy at the zero bound. This includes expectations about the central bank’s objectives for inflation and the economy, and expectations about how the central bank will use its tools in the future to achieve these goals. Second, in managing expectations, good communication is essential. Expectations will not be well anchored when communications are muddled or inconsistent, or when a central bank acts in ways that are not consistent with its guidance. Third, actions speak louder than words alone. Thus, there is an important role for asset purchases that ease financial conditions to support growth and keep inflation expectations well anchored. Fourth, the policy instruments interact so that policy as a whole exceeds the sum of its parts. Fifth, at the zero lower bound, risk management becomes extremely important. In particular, because the costs of getting stuck in a liquidity trap with chronic deflation are high, a central bank should put substantial weight on avoiding this outcome. Sixth, the constraints imposed by the zero bound limit what monetary policy can accomplish by itself. This increases the importance of complementary fiscal, financial, and structural policy actions. Credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth are very important.