An interesting research note out of the SF Federal Reserve says that policy makers may be forced to keep rates near zero for years to come:

The shaded area in Figure 2 is the difference between the current zero-constrained level of the funds rate and the level recommended by the policy rule. It represents a monetary policy funds rate shortfall, that is, the desired amount of monetary policy stimulus from a lower funds rate that is unavailable because nominal interest rates can’t go below zero. This policy shortfall is sizable. Indeed, the Fed has been able to ease the funds rate only about half as much as the policy rule recommends. It is also persistent. According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years. The policy shortfall persists even though the economy is expected to start to grow later this year. Given the severe depth of the current recession, it will require several years of strong economic growth before most of the slack in the economy is eliminated and the recommended funds rate turns positive.

The Federal Reserve is employing all available tools to promote economic recovery and price stability by lowering borrowing costs and boosting credit availability. In particular, after lowering the federal funds rate to essentially zero, the Fed has turned to unconventional policy tools to help accomplish its goals. Eventually, as the economy recovers, it will be appropriate for the Fed to reduce the size of its balance sheet toward pre-crisis levels and to raise the funds rate, and the Fed has both the means and the determination to do so.

The Fed has been pushing on a string for nearly two years now.  It’s baffling why a failed policy approach continues to be the course of action.  There seems to be relatively little debate that low rates in 2001-2002 caused the housing crisis and contributed to the debt crisis.   Common sense would tell us that more debt via lower interest rates isn’t the logical solution here.  Did Bernanke and Co. ever consider the fact that maybe the system needs to be flushed of the debt before it can recover?

Some readers will recall the debate in 2007 about low rates and how the Fed would be forced to raise rates rapidly when signs of recovery were evident.  This report seems to contradict such thinking, but I believe higher rates later this year is the more likely scenario.