Down The Rabbit Hole: SF Fed President John Williams Seeks “Direct Attack” On Low Inflation

San Francisco Fed president John Williams has been yapping about the need for interest rate hikes, 4% inflation targets, and Fed-set GDP growth targets.

Williams is bullish on jobs. He also says the US economy is at “full strength” but inflation needs to be higher now so we can cut rates later.

His speech to the Hayek Group in Reno Nevada was called Whither Inflation Targeting? Here are some excerpts:

Good evening; it’s a pleasure to be here to discuss the economy and monetary policy with the Hayek Group. I’ll start with a quick overview of the U.S. economic outlook and what it means for monetary policy. Spoiler alert: The punch line is that the economy has climbed back to full strength, and it therefore makes sense to move monetary policy gradually back to normal. That brings me to the second topic of my talk: What is “normal” monetary policy?

Our goal is not to have an unemployment rate of zero. Instead, it’s to be near the “natural rate” of unemployment: That’s the rate we can expect in a healthy economy. It’s impossible to know exactly what that number is, but economists generally put it between 4¾ and 5 percent today.1 With the unemployment rate at 4.9 percent, we’re right on target.

Turning to the other side of the ledger, the Fed’s monetary policy committee—the Federal Open Market Committee, or FOMC for short—has set a long-run goal of 2 percent inflation. Inflation has been running persistently below that goal for several years.

We’re not quite at our target yet, but the combination of fading transitory factors and a strong economy should help us get back to our 2 percent goal in the next year or two.

To sum up, I remain confident about the road we are on.

What it Means for Interest Rates

So, what does this mean for interest rates? In the context of a strong economy with good momentum, it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later. Let me be clear: In arguing for an increase in interest rates, I’m not trying to stall the economic expansion. It’s just the opposite: My aim is to keep it on a sound footing so it can be sustained for a long time.

History teaches us that an economy that runs too hot for too long can generate imbalances, potentially leading to excessive inflation, asset market bubbles, and ultimately economic correction and recession. A gradual process of raising rates reduces the risks of such an outcome.

What is Normal Monetary Policy?

New realities pose significant challenges for the conduct of monetary policy in the United States and elsewhere. Foremost is the significant decline in the natural rate of interest, or r* (r-star), over the past quarter-century to historically low levels.

The daunting challenge for central banks is how to deliver stable inflation in a low r-star world. This conundrum shares some characteristics and common roots with the theory of secular stagnation; in both scenarios, interest rates, growth, and inflation are persistently low.

How Low Can Rates Stay?

In a recent paper, Kathryn Holston, Thomas Laubach, and I estimated the inflation-adjusted natural rate for four major economies: the United States, Canada, the euro area, and the United Kingdom. In 1990, estimates ranged from about 2½ to 3½ percent. By 2007, on the eve of the global financial crisis, these had all declined to between 2 and 2½ percent. By 2015, all four estimates had dropped sharply, to 1½ percent for Canada and the United Kingdom, nearly zero for the United States, and below zero for the euro area.

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. 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 stability and full employment.

Low R-Star and Strategies for Mitigation

There are actions that central banks and governments can undertake to avoid this fate. These include fiscal and other policies aimed at raising the natural interest rate, as well as alternative monetary, fiscal, and other policies that are more likely to succeed in maintaining a strong economy and stable inflation in the face of a low natural rate.

Although inflation targeting central banks that aimed for a low inflation rate generally have been successful at stabilizing inflation in the past, such an approach is not as well-suited for a low r-star era. There simply may not be enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low.

The most direct attack on low r-star would be for central banks to pursue a somewhat higher inflation target. This would imply a higher average level of interest rates and thereby give monetary policy more room to maneuver. The logic of this approach argues that a 1 percentage point increase in the inflation target would offset the deleterious effects of an equal-sized decline in r-star.

A second alternative would be to replace the inflation target with a flexible price-level or nominal GDP target, where the central bank targets a steadily growing level of prices or nominal GDP, rather than the rate of inflation.

Because they provide a clear metric by which to judge whether the economy is above or below the stipulated goal, they may help improve the systematic conduct of policy and its communication and public understanding, especially when interest rates are constrained by the lower bound.

Of course, like a higher inflation target, these approaches also have potential disadvantages that must be carefully scrutinized when considering their relative costs and benefits.

Time is not on our side. We have witnessed the extreme difficulties of achieving price stability and full employment with a low r-star. I firmly believe that now is the time for experts and policymakers around the world to actively study and assess the pros and cons of alternative proposals, so that we are better prepared for the challenges related to persistently low natural real rates of interest.