Monetary policy in a low r-star world

This short paper by John Williams of San Francisco Fed is doing rounds.

Williams says much of the developed world is stuck in a low r star or the neutral rate:

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. Our understanding of the economy and monetary policy are underpinned by the concept of the natural interest rate—that is, the short-term real (inflation-adjusted) interest rate that balances monetary policy so that it is neither accommodative nor contractionary in terms of growth and inflation. In this Letter, I focus on the medium-term value of the natural rate—essentially what inflation-adjusted interest rates will be in an economy at full strength.

While a central bank sets its short-term interest rate, r-star is a function of the economy that is beyond its influence. The new 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 (Summers 2015).

This post argued how central banks do not allow the neutral rate to be seen. Infact, what is seen as a Wicksellian idea is just a Keynes one. Wicksell talked about natural rates which emerge from market interactions whereas Keynes spoke about the neutral rate which prevails in equilibrium where output and employment are such that the elasticity of employment as a whole is zero”. 

So what are his solutions? Higher education, higher investments in infrastructure, fiscal stimulus and higher inflation target:

Taking each of those in turn, I’ll start with policies aimed at raising r-star by affecting its underlying determinants. One potential avenue is to increase longer-run growth and prosperity through greater long-term investments in education, public and private capital, and research and development. Despite growing skepticism and endless column inches questioning whether college is worth the cost, the return on investment in post-secondary education is as high as ever (Autor 2014, Daly and Cao 2015). Likewise, returns on infrastructure and research and development investment are very high on average (Jones and Williams 1998, 2000, Fernald 1999).

Turning to policies that can help stabilize the economy during a downturn, countercyclical fiscal policy should be our equivalent of a first responder to recessions, working hand-in-hand with monetary policy. Instead, it has too often been stuck in a stop-and-go cycle, at times complementing monetary policy, at times working against it. This is not unique to the United States; Japan, and Europe have also fallen victim to fiscal consolidation in the midst of an economic downturn or incomplete recovery.

One solution to this problem is to design stronger, more predictable, systematic adjustments of fiscal policy that support the economy during recessions and recoveries (Williams 2009, Elmendorf 2011, 2016). These already exist in the form of programs such as unemployment insurance but are limited in size and scope. Some possible ideas for the United States include Social Security and income tax rates that move up or down in relation to the national unemployment rate, or federal grants to states that operate in the same way. Such approaches could be designed to be revenue-neutral over the business cycle; they also could avoid past debates over fiscal stimulus by separating decisions on countercyclical policy from longer-run decisions about the appropriate role of the government and tax system. Indeed, economists across the political spectrum have championed these ideas (Elmendorf and Furman 2008, Taylor 2000, 2009).

Finally, monetary policy frameworks should be critically reevaluated to identify potential improvements in the context of a low r-star. Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star era. 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.

Two alternatives can be considered together or in isolation to address this issue. First, 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 (Williams 2009; Blanchard, Dell’Ariccia, and Mauro 2010; Ball 2014)……

Second, inflation targeting could be replaced by a flexible price-level or nominal GDP targeting framework, where the central bank targets a steadily growing level of prices or nominal GDP, rather than the rate of inflation.

Summers says Williams is not pushing the fiscal story much.

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 in a paper by Brad DeLong and myself and the International Monetary Fund. 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 probably 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 earned-income-tax-increase 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 zero-lower-bound 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 wrong by setting a level target of 4 to 5 percent growth in nominal gross domestic product and think that there could be substantial benefits. (I expect to turn to this topic in the not too distant future.)


One could conduct this another monetary experiment of raising the inflation targets. It is being talked about a lot. How much more worse can things actually get? In all this it is being forgotten that inflation is running below 2% target set by most advanced economies for a while now. Central banks are unable to achieve 2% despite much easing  and we think they would be able to achieve a higher target!

How economics is being reduced to certain relationships via models. So keep tinkering with these variables and hopefully something will work. It worked earlier but now the patient is throwing up with whatever medicine is being given. What the patient perhaps requires is more freedom to heal on its own and is sick of all these medicines.


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