San Francisco Fed president calls for inflation policy rethink

Bank official argues 2% target not suitable
Federal Reserve President John Williams
John Williams, president of the Federal Reserve Bank of San Francisco

Central banks need to consider aiming for a higher inflation target as they boost their room for manoeuvre in the context of a sluggish economic environment, a senior Federal Reserve policymaker has said.

John Williams, the president of the Federal Reserve Bank of San Francisco, said the current 2 per cent inflation target is not well suited to an economy with a depressed natural interest rate — the rate consistent with an economy operating on an even keel.
“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,” he said. A higher inflation target “would imply a higher average level of interest rates and thereby give monetary policy more room to manoeuvre”.

The change was one of several that could be considered as officials revamp established approaches to monetary and fiscal policy in order to take into account depressed natural rates of interest, Mr Williams said.

Among the others would be for the central bank to target a given level of prices or nominal output, or for politicians to institute a more active role for budgetary policy in stimulating the economy, for example by automatically varying tax and spending plans in line with the economic cycle.

“There are limits to what monetary policy can and, indeed, should, do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability,” said Mr Williams in an “economic letter” published by the San Francisco Fed on Monday.

Mr Williams’s intervention comes amid an intensifying debate within the Fed over the implications of America’s stubbornly slow economic recovery, and how officials should respond to it.

Economists led by Larry Summers, former Treasury secretary, have been proposing the sobering theory that the US may be mired in so-called secular stagnation — a trap of lethargic economic growth and depressed interest rates. That view has been gaining more currency within the Fed itself.

Mr Williams’s intervention comes just ahead of the Fed’s annual symposium in Jackson Hole, Wyoming, where the depressed natural rate of interest, low inflation and the muted economic recovery are likely to feature in discussions.

Estimates of inflation-adjusted natural rates by economists including Mr Williams have been sliding across a range of leading economies in the recent years amid pedestrian growth.

Mr Williams argued that the underlying drivers for these declines included ageing populations, slower trend productivity, emerging markets seeking large reserves of safe assets, and a broader worldwide glut of savings. “The key takeaway from these global trends is that interest rates are going to stay lower than we’ve come to expect in the past,” he argued.

In suggesting a higher inflation target, Mr Williams is echoing calls from Olivier Blanchard, the former chief economist of the International Monetary Fund, who in 2010 argued that policymakers should shoot for higher inflation to increase the room for monetary policy to react to shocks.
Eric Rosengren, the Boston Fed president, made a similar suggestion last year in an interview with the Financial Times, arguing that if inflation targets were set higher, it could mean a higher long-run policy rate for the Fed, which would leave a bigger cushion for cutting rates in a downturn before hitting zero.
The Fed instituted a formal 2 per cent inflation target in 2012 under former chairman Ben Bernanke, pursuant to a dual mandate under which it seeks maximum employment and price stability. The central bank has struggled to hit its inflation goal ever since.

Lifting the inflation target was only one of a range of reforms at central banks that Mr Williams put forward in response to the current environment of depressed natural rates of interest. Another answer would be to target a steadily growing level of prices, or indeed nominal gross domestic product, rather than inflation as at present.

“In stressing the need to study and consider new approaches to fiscal and monetary policy, I am not advocating an abrupt reversal of course; after all, you don’t change horses in the middle of a stream,” he cautioned. “But now is the time for experts and policymakers around the world to carefully investigate the pros and cons of these proposals.”

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