Central Bankers’ Main Challenge: Staying Relevant

Decline in the natural interest rate gives authorities less ammunition to counteract economic shocks

By Greg Ip

Former Treasury Secretary Larry Summers has advocated deficit-financed government infrastructure as a cure for slow growth, but central bankers are nervous about coordinating with politicians. Photo: David Paul Morris/Bloomberg News

When central bankers gather this week in Jackson Hole, Wyo., they will be consumed not with some pressing crisis in the global economy but by an existential threat to their relevance.

The threat stems from the realization that the sluggish economic growth that has prevailed since 2009 may be here to stay. If so, then so are today’s low interest rates.

Central banks set interest rates to balance investment and savings and thus keep economies fully employed and inflation stable. The interest rate that achieves that balance is called the natural rate.

The fact that inflation and growth are now so sluggish despite ultra-easy monetary policy shows that the natural rate has fallen—by 1 to 2.5 percentage points since 2007 in the U.S., Canada, Britain and the eurozone, according to a recent Fed study. Fed policy makers think the U.S. natural rate is 3%, down from 4.5% before the recession. That’s 1.5 percentage points less ammunition to counteract the next shock to the economy.

Initially, central bankers thought the drop in the natural rate was transitory as households, businesses and governments tried to pay down debt or borrow less. With time, it has become clear more deep-seated forces are at play: A slump in productivity growth has depressed the return on, and demand for, new equipment. An aging population needs fewer malls, office buildings and houses. Rising inequality has tilted more income toward the high-saving rich.

Risk aversion world-wide has heightened the demand for safe government bonds.


In dealing with this new normal, policy makers are considering three possible responses, all of which have drawbacks.

Accept the status quo: The growth slowdown may not be permanent. Or, the economy may have changed in ways that make future recessions less severe: For example, housing is less important and inflation is better anchored.

And the Fed has ammunition beyond just short-term rates. In a recent paper, David Reifschneider, a Fed economist, calculates that the unconventional tools the Fed has employed in recent years, such as buying government bonds by creating money or committing to keep rates at zero, can make up for the inability of rates to go much below zero.

Still, this is hardly ideal. Another round of bond buying would further expand the Fed’s share of publicly held federal debt, now at 18%. Critics think this may give fiscal considerations too much sway in monetary policy. More worrisome, these less orthodox steps can incentivize speculative excesses, as even advocates of the policies acknowledge. “Does a low-rate…environment that lasts for a long time create conditions that might pose risks to financial stability?…I think the answer is probably yes,” Fed governor Dan Tarullo said last month.

Fix underlying growth: Former Treasury Secretary  Larry Summers, now at Harvard University, has been the most vocal advocate of curing slow growth directly with deficit-financed government infrastructure. This would both raise public investment and, by easing bottlenecks, incentivize private investment as well.

The Fed would have no direct role in this. It could, however, team up with the Treasury by promising to buy the bonds that finance the infrastructure, a largely untried form of stimulus dubbed “helicopter money.”

But central bankers are nervous about coordinating with politicians. Even ordinary deficit financing has proven unpopular with debt-wary governments. For maximum effect, all countries would have to expand their deficits. If only the U.S. did, it would push up interest rates and the dollar, sucking in imports and thus diluting the benefit.

And policy fixes are much more limited if slow growth is driven by demographics or a dearth of technological advances. “Monetary policy is not well equipped to address long-term issues like the slowdown in productivity growth,” the Fed’s vice chairman, Stanley Fischer, said this week.

Change the target: Central bankers settled on a 2% inflation target to minimize the inflationary boom-bust cycles of 1966 to 1982 and the inefficiencies bred by frequently changing prices. Yet there’s little evidence that 3% or 4% inflation would do more harm than 2%. Because higher average inflation translates to a higher natural interest rate, the higher target would provide more scope to ease without turning to tools such as quantitative easing.

Economists in the past have argued for a different target. The Fed has demurred, until now.

Last week John Williams, president of the Federal Reserve Bank of San Francisco and a respected monetary scholar, put the idea out for discussion.

Would simply announcing a higher target matter, considering central banks have struggled to get inflation even to 2%? It took massive bond buying for Japan to push inflation back above zero but 2% remains elusive. It might be possible to let the economy overheat long enough to push inflation higher, but as Goldman Sachs GS -0.47 % economists note, it might take a recession to cool it off.

For central bankers, all the choices are unsettling. But at least, Mr. Williams notes, they know what they’re up against: “We can wait for the next storm and hope for better outcomes or prepare for them now and be ready.”

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