Modern societies have been accustomed to economic growth due

to advancement of new technologies and an expanding workforce.

However, over long periods or phases of economic growth,

it is not uncommon for a country to face an extended period of slow growth.

An economic deceleration will have implications for many aspects of society.

Indeed this may create instability in the economy.

In fact, impacting the work of the central bank.

In this segment we ask,

how do central banks deal with a persistent economic slowdown?

Due to a persistent decline in economic growth,

Japan has faced deflationary conditions for a persistent period.

The central bank has responded by cutting policy interest rates.

However, various factors keep

the central bank from pushing interest rates much below zero.

With the traditional monetary policy operating target pushed to the zero lower bound,

the central bank has chosen unconventional monetary policy tools.

After viewing this segment,

you should be able to: One,

calculate the benchmark interest rate with the Taylor rule.

Two, identify unconventional policies.

In the 21st century,

advanced economies around the world have

experienced a downturn in economic growth prospects.

There are a number of possible explanations.

Some people attribute this to demographics which are reducing the available workforce.

Others point to a slowdown in technological advance.

Regardless, no country has experienced this growth deficit more severely than Japan,

which has been experiencing slow growth since the turn of the millennium.

This chart shows that other G7 countries have

experienced a similar slowdown in more recent periods.

The whole economic growth potential in

Japan has led to a decline in corporate investment.

The decline in demand relative to potential is

reflected in Japan's persistently negative output gap.

World demand has translated into low inflation.

Since the early '90s,

inflation has been low and usually negative,

meaning consumer prices are largely falling.

We know that the bank of Japan has a mandate to achieve inflation of 2 percent,

but currently inflation is far below that 2 percent level.

What interest rate should the bank of Japan set in order to achieve the inflation target?

To answer this question,

the economist Knut Wicksell,

introduced the concept of the natural interest rate.

The hypothetical interest rate that would bring inflation to the stable target.

Historically, the operational target is the overnight uncollateralized call money rate,

which is the name in Japan for the inter bank lending rate.

Given the under performance of inflation,

the central bank should be cutting interest rates.

Indeed, the bank of Japan sharp point cut interest rates in the 1990s,

since when it has been flat near zero.

However, even these low rates have not been sufficient to bring inflation to target.

More recently, the economist John Taylor,

has proposed an estimate of the natural rate which is

based on the average of the output gap and the inflation gap.

The inflation gap, is the gap between the inflation and the inflation target.

Remember, the output gap is a percentage deviation of GDP from potential GDP.

Taylor's proposed estimate of the natural interest rate

can be constructed with a formula called the Taylor Rule.

Start with the long term real interest rate which we call r star,

add the current inflation rate as a baseline interest rate,

add to this the average of the output gap and the inflation gap.

When the output gap is positive or inflation is above target,

we should raise interest rates above baseline to slow down demand and inflation.

When the output gap is negative and or inflation is below target,

we will need to cut interest rates below baseline to stimulate demand.

In order to construct Taylor's estimate of the natural interest rate,

we must first estimate the long term real interest rate.

An important complication is that the slowdown of

economic growth has created a fundamental change in global bond markets.

The global growth slowdown has pushed down the long run interest rate.

The reason is that a decline in corporate investment has changed the terms of borrowing,

and now lenders can expect to lower interest rates on their loans.

There are complicated models to estimate r star.

But a simple proxy is

the long term growth rate which can be measured as the growth rate of potential output.

In Japan, this has been at very low levels since 1990.

Potential growth in the 1980s was robustly above three and a half percent.

But since then, has been usually below 1 percent.

There are a number of factors that led to this slowdown,

but an important one was demographic.

The growth in the size of the labor force has been slow and even falling in recent

years.We can use data from Japan

along with the Taylor Rule to estimate a target for the natural interest rate.

From the second quarter of 2016,

the Bank of Japan reports a growth rate of potential output of 0.74 percent,

which we use as a proxy for r star.

Inflation of negative 0.33 percent,

combined with an inflation target of 2 percent,

implies an inflation gap of negative 2.33 percent.

While the output gap is negative 0.35 percent.

We use the Taylor rule,

decimate the national interest rate as negative 0.93 percent.

So, according to the Taylor rule,

we need to set the interest rate at negative 0.93 percent to stimulate

demand sufficiently to bring inflation to the target level of 2 percent.

Use the Taylor rule and Japanese data to

estimate the natural interest rate in Japan in recent years.

The Taylor rule suggests that the interest rate necessary to

generate enough demand to hit the inflation target is often negative.

What does a negative interest rate mean?

It means that if you borrow money,

the lender actually has to pay the borrower extra money to agree to borrow.

Can interest rates even go into negative territory?

Remember, paper money pays zero interest rate.

Would anyone be willing to lend money at a negative interest rate,

when they could just hold on to cash and avoid making an extra payment to borrowers?

Return to the liquidity preference model,

in which the inter-bank rate is set by the supply and demand of liquidity.

The Bank of Japan has offered an interest rates of 0.1 Percent on deposits since 2008.

The central bank can rapidly bring down the interest rate through open market operations.

As the central bank increases the supply of liquidity sufficiently,

the interest rate in the inter-bank market may fall

to the deposit facility rate a 0.1 percent

and commercial banks have tended to hold

their funds on reserve at a very small interest rate,

rather than lend it out to other banks at lower rates.

However, in 2016, that interest on

the deposit facility was adjusted from positive to negative.

At negative interest rates in the deposit facility,

banks might be willing to lend money to each other at negative rates,

rather than pay the central bank to keep their funds on reserve with the central bank.

Taking a closer look,

the central banks sets a policy rate to target the interest rate on inter-bank lending.

In Japan the policy rate is the interest rate on

the deposit facility called the Complimentary Deposit Facility Interest Rate.

This remained at 10 basis points for the first half of the decade.

The overnight interest rate tracked this facility rate.

In 2016, the central bank adjusted the deposit facility rate to negative territory.

This means that any commercial bank holding excess reserves at the central bank,

must actually pay a fee to the central bank.

Rather than pay this fee,

banks have been willing to lend money in

the inter-bank market at negative interest rates.

When the call rate is negative,

that means that a bank needs to pay to lend.

Commercial banks could in theory hold their reserves in

the form of currency rather than keeping deposit to the central bank.

This would allow them to avoid the interest costs when the policy rate is negative.

However, in practice, the cost of assembling and storing hundreds of trillions of yen,

would make this difficult.

The Bank of Japan describes this current monetary policy as

quantitative and qualitative monetary easing with yield curve control.

This is three parts.

One, yield curve control.

Two, inflation overshooting and three unconventional asset purchases.