by John C. Williams, San Fransisco Fed President
15-Aug (SF Fed) — Central banks and governments around the world must be able to adapt policy to changing economic circumstances. The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest. While price level or nominal GDP targeting by monetary authorities are options, fiscal and other policies must also take on some of the burden to help sustain economic growth and stability.
As nature abhors a vacuum, so monetary policy abhors stasis. Instead of being a rigid set of precepts, it follows the adage, that which survives is that which is most adaptive to change. Over the past century, monetary policy strategies have evolved in response to changing realities, from the panics and depressions of the late 19th and early 20th centuries that led to the creation of the Federal Reserve to the Great Depression, from Bretton Woods and subsequent battles to contain inflation to the dominance of inflation targeting today (Williams 2014, 2015a).
In the wake of the global financial crisis, monetary policy has continued to evolve, in this latest incarnation battling low inflation and stagnation via unconventional monetary policy actions like quantitative easing and near-zero or even negative interest rates. As we move forward, economic conditions require that central banks and governments throughout the world carefully reexamine their policy frameworks and consider further adjustments in terms of monetary policy strategy—both in its own right and as it relates to other policy arenas—to successfully navigate these new seas.
…In the post-financial crisis world, however, new realities pose significant challenges for the conduct of monetary policy. Foremost is the significant decline in the natural rate of interest, or r* (r-star), over the past quarter-century to historically low levels.
…A variety of economic factors have pushed natural interest rates very low and they appear poised to stay that way. This is the case not just for the United States but for other advanced economies as well.
…The critical implication of a lower natural rate of interest is that conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. This will necessitate a greater reliance on unconventional tools like central bank balance sheets, forward guidance, and potentially even negative policy rates. In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher (Reifschneider and Williams 2000). We have already gotten a first taste of the effects of a low r-star, with uncomfortably low inflation and growth despite very low interest rates. Unfortunately, if the status quo endures, the future is likely to hold more of the same—with the possibility of even more severe challenges to maintaining price and economic stability.
To avoid this fate, central banks and governments should critically reassess the efficacy of their current approaches and carefully consider redesigning economic policy strategies to better cope with a low r-star environment. This includes considering fiscal and other policies aimed at raising the natural interest rate, as well as alternative monetary and fiscal policies that are more likely to succeed in the face of a low natural rate.
…Policymakers don’t often cite Machiavelli, but in this instance, the analogy is potent (and, perhaps, a portent). In The Prince, fortune is compared to a river; in times of turbulence it wreaks havoc, flooding and destroying everything in its way. But in calm and sedate weather, people can build dams and stem the tide of destruction. In other words, we can wait for the next storm and hope for better outcomes or prepare for them now and be ready.
PG View: To me it seems like nobody has done anything to prepare for the next storm, all the central banks have encouraged greater credit expansion and discouraged savings; the very things that got us in trouble in the first place.