A Thought Provoking Essay from Fed President William


John Williams has written the most thoughtful piece on monetary policy that has come out of the Fed in a long time.  He recognizes more explicitly than others that r* (r-star), the neutral interest rate, is now very low and quite likely will remain very low for a long time to come.  As he recognizes, this the essence of the secular stagnation concern that I and others have been expressing for the last 3 years.

I now believe that it just as reasonable to suppose that neutral rates will fall further as it is to suppose they will revert towards historically normal levels.  First, there is a kind of hysteresis in rates in which a lower interest rate today tends to lower the neutral rate in the future.  To the extent that low rates stimulate spending by pulling forward investment, low rates today reduce neutral rates tomorrow by moving investment forward.  Second, major structural factors like rising inequality, slowing labor force  growth, lower capital goods prices, slowing productivity growth  and more capital outflows from developing countries appear to represent continuing trends.  Third, there is the prospect that the growing expectation that rates will be low for a long time decreases the spending of target savers and interferes with financial intermediation.

Wlliams rightly if rather tentatively draws the conclusions that a chronically very low neutral rate has important policy implications.  He stresses the desirability of raising r* by pursuing structural policies to raise growth and affirms the importance of fiscal policy.  I yield to no one in my enthusiasm for improved education and educational opportunity but I do not think it is plausible that it will change the neutral rate appreciably in the next decade given that the vast majority of the 2030 labor force will be unaffected.

If Williams is overenthusiastic on education, he is under enthusiastic on fiscal stimulus.  He fails to emphasize the supply side benefits of infrastructure investment that likely enable debt financed infrastructure investments to pay for themselves as suggested by DeLong and Summers and the IMF.  Nor does he note at current interest rates an increase in pay as you go social security could provide households with higher safe returns than private investments.  More generous Social Security would likely reduce the saving rate, thereby raising the neutral interest rate with no change in budget deficits.  Nor does Williams address the possibility of tax measures such as incremental investment credits or expansions in the EITC financed by tax increases on those with a high propensity to save.  The case for fiscal policy changes in the current low r*’environment seems to me overwhelming and much can be accomplished without any increase in deficits.

Williams comments on monetary policy have generated more interest.  He makes the now familiar point that if negative real rates are sometimes desirable on counter cyclical grounds there is a strong argument for an inflation target high enough that the ZLB does not bind or binds only very infrequently.  If the Fed believed that a 2 percent inflation target was appropriate at the beginning of 2012 when it believed the neutral real rate was above 2 percent, I cannot see any argument for not adjusting the target or altering the framework when the neutral real rate is very plausibly close to zero.  The benefits of a higher target have increased and so far as I can see nothing has happened to change the cost of a higher target,

I am disappointed therefore that Williams is so tentative in his recommendations on monetary policy.  I do understand the pressures on those in office to adhere to norms of prudence in what they say.  But it has been years since the Fed and the markets have been aligned on the future path of rates or since the Fed’s forecasts of future rates have been even close to right. I cannot see how policy could go badly wrong by setting a level target of 4 to 5 percent growth in nominal GDP and think that there could be substantial benefits. (I expect to return to this topic in the not too distant future)

Moreover even accepting the current framework, I find the current policy framework hard to comprehend.  If as it asserts, the Fed is serious about the 2 percent inflation target being symmetric there is an anomaly in its forecasts.   Surely if, as the Fed forecasts, the economy enters a 10th year of recovery with unemployment below five percent inflation should be expected to be above 2 percent at that point.  How else could inflation average 2 percent over time given the likelihood of downturns and recessions?

Finally there is this:  Everything we know about business cycle history suggests an overwhelming likelihood that there will be downturns in the industrial world sometime in the next several years.  Nowhere is there room to cut rates by anything like the normal 400 basis points in response to potential recession.  This is the primary monetary and indeed macroeconomic policy challenge of our generation.  I hope it will be very much in focus at Jackson Hole.

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