Federal Reserve Bank of San Francisco President John Williams called for monetary and fiscal policy makers to rethink the way they operate, saying America is getting a taste of a new economic normal that warrants a change in orthodoxy.
Williams’ analysis centres on the idea that neutral interest rates — those that neither stoke nor slow the economy — are historically depressed and are poised to stay that way. To better adapt, he urged governments to prepare to provide a stronger fiscal backstop and central bankers to consider scrapping the practise of targeting low inflation.
“We can wait for the next storm and hope for better outcomes or prepare for them now and be ready,” Williams wrote in an essay published Monday by the San Francisco Fed. While he isn’t a voting member of the policy-setting Federal Open Market Committee this year, Williams is one of the foremost experts on the natural interest rate.
Williams, who was Fed Chair Janet Yellen’s top policy adviser when she was San Francisco Fed chief, joins a chorus of central bankers calling for stronger fiscal measures and a rethink as years of ultra-low interest rates and unconventional policies fail to stimulate breakout growth.
He’s also the second Fed policy maker in two months to suggest a major break with how the US central bank conducts itself. The St. Louis Fed’s James Bullard on June 17 announced that he would stop submitting long-term economic forecasts and lowered his rate projection to one hike in 2016 and none during 2017 and 2018, based on his thinking that the economy is in a new, low-productivity and low-growth regime.
Williams’s comments come ahead of next week’s symposium hosted by the Kansas City Fed in Jackson Hole, Wyoming, where top global central bankers and economic thinkers will gather to discuss how to design resilient monetary policy.
For central banks, the long-standing mantra of targeting a low inflation rate is no longer appropriate in an era of low interest rates, Williams wrote.
“There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low,” he said in the essay. The Fed adopted its 2 per cent inflation target in January 2012.
Williams suggested either setting a higher inflation goal or replacing the practise with something else. Options include flexible price-level targeting or aiming for levels of nominal gross domestic product.
While Williams has previously said that policy makers should explore their alternatives for dealing with a low-rate world and has put forth the idea of a higher inflation target, his essay takes a more forceful tack, arguing that “we are seeing the future now” and “reviewing the key aspects of inflation targeting is certainly necessary.”
Williams was careful to note that he isn’t “advocating an abrupt reversal of course,” which could be disruptive. “But now is the time for experts and policy makers around the world to carefully investigate the pros and cons of these proposals.”
Shifting demographics, slower productivity and economic growth and the fact that emerging markets are seeking large reserves of safe assets have all lowered the natural interest rate, according to his analysis. That means conventional monetary policy has less room to stimulate the economy, Williams wrote, suggesting that the neutral rate may have fallen from 4 per cent to 4.5 per cent in the short term to a new normal of 3 per cent to 3.5 per cent, or even lower.
With less wiggle room, central banks will have to turn to other tools such as balance sheets, communications and “potentially even negative policy rates,” he wrote. Recessions will be deeper, recoveries slower and the risk of unacceptably low inflation will be higher.
On the fiscal side, Williams advocated creating a more robust framework to help stimulate the economy in case of a downturn, since monetary policy will be less powerful.
He floated the idea of designing “stronger, more predictable, systematic adjustments of fiscal policy that support the economy during recessions and recoveries,” such as tying Social Security benefits or income tax rates to the national unemployment rate.