A Bank of Italy paper illustrates the detrimental effect of a “negative cost push shock” (for example a commodity price drop) on an economy with low inflation and interest rates close to zero (such as the euro area). In normal times a downside cost shock would boost output. At the zero lower bound for rates, however, it would trigger a contraction, due to rising real rates and debt service.
William Dudley provided an update of the Fed’s strategy for normalizing monetary policy. Under appropriate economic conditions, policy rates could begin rising in 2015, a considerable time after open-ended asset purchases have ceased. Rates increases would be tempered by tightening financial conditions and are seen to converge on a level below 4%. Discretionary balance sheet reduction should follow, not precede, rates normalization. Large excess reserves are not expected to compromise control over short-term interest rates.
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