Too Low for Zero

The Taylor rule describes how the Fed adjusts monetary policy (by changing the target for the Fed funds rate) in response to output and inflation. The San Francisco Fed's Glenn Rudebusch plugged the Fed's forecasts for inflation and the output gap into the Taylor rule, and found that the Fed funds rate should be headed deep into negative territory:The problem is that nominal interest rates cannot be negative; it is better to hold money and earn no interest than lend it and get less back in the future. Thus, monetary policy is up against the "zero lower bound" (which it reached in Dec. 2008, when the Fed lowered the Fed funds target to a range of 0-0.25%), forcing the Fed to improvise. Rudebusch explains:

Toward the end of 2008, the recession deepened with the prospect of a substantial monetary policy funds rate shortfall. In response, the Fed expanded its balance sheet policies in order to lower the cost and improve the availability of credit to households and businesses. One key element of this expansion involves buying long-term securities in the open market. The idea is that, even if the funds rate and other short-term interest rates fall to the zero lower bound, there may be considerable scope to lower long-term interest rates. The FOMC has approved the purchase of longer-term Treasury securities and the debt and mortgage-backed securities issued by government-sponsored enterprises. These initiatives have helped reduce the cost of long-term borrowing for households and businesses, especially by lowering mortgage rates for home purchases and refinancing.

In terms of overall size, the Fed's balance sheet has more than doubled to just over $2 trillion. However, this increase has likely only partially offset the funds rate shortfall, and the FOMC has committed to further balance sheet expansion by the end of this year. Looking ahead even further over the next few years, the size and persistence of the monetary policy shortfall suggest that the Fed's balance sheet will only slowly return to its pre-crisis level.

That is, the usual adjustments to the Fed funds rate affect the short end of the yield curve (the relationship between interest rates and maturity of debt), but now the Fed is creating money to buy longer-term securities. Because bond prices and yields move in opposite directions, this should reduce rates further along the curve.