Several months after St. Louis Fed president James Bullard infamously flipped from one of the Fed's most vocal hawks to the dovish equivalent of Kocherlakota, no longer expecting more than 1 rate hike over the next two years, earlier today another legacy dove, today San Fran Fed president John Williams published a letter titled "Monetary Policy in a Low R-star World", in which he recommended an overhaul of policy orthodoxy.
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.
Specifically, he urged central bankers and governments to come up with new policies to buffer their economies against persistently low interest rates that threaten to make future recessions deeper and more difficult to avoid.
In the letter, Williams focused on the r* (or r-star), also known as the natural rate of interest, which as we have written extensively about previously and which represents the rate which neither stokes nor slows the economy, and also represents a proxy of the maximum potential Fed Funds rate, beyond which the economy would by definition overheat. The letter was inspired by what Ben Bernanke wrote one week ago in his latest blog post, in which he covered the topic of the natural rate of growth and further discussed "the ongoing shift in the Fed’s economic views." This is what Williams said:
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).
Williams’ analysis centers on the idea that neutral interest rates, are not only historically depressed but may be set to decline further. The following chart from Bloomberg shows a widely accepted calculation of r* using the Williams-Laubach methodology, according to which the US natural rate of interest is as of this moment effectively zero, and as such the appropriate Fed Funds rate is also zero.
With r-star at zero, monetary policy is virtually helpless to boost growth while keeping inflation low, and as a result he urged governments to prepare to provide a stronger fiscal backstop and central bankers to consider scrapping the practice of targeting low inflation; in order words he is pushing for monetary policy that overheats the economy and leads to inflation that is higher than the Fed's target rate of 2%. Setting higher inflation targets, tying monetary policy directly to economic output, instituting government spending programs that automatically kick in during economic downturns, and boosting investment in education and research are all policies that should be considered. Without such changes, Williams warned, policymakers will find themselves hamstrung.
"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," Williams said.
In other words, Williams demands a full-blown bazooka treatment from policy makers not only at the Fed, but also in Congress. The irony is that by his demand, Williams admits that the past 7 years of monetary policy have effectively failed to stimulate the economy, even if the S&P500 does find itself at all time highs.
However, instead of admitting they were wrong, central bankers have once deflected and blamed "factors beyond their control, including an aging population and sluggish productivity gains, are braking growth."
As a result, Williams is convinced that it is these factors that are keeping interest rates from rising: Williams estimated U.S. short-term rates would likely rise only to 3 percent or 3.5 percent even after the economy regains full health, and perhaps not even that.
The timing of Williams' call, as Reuters notes, in the midst of a U.S. presidential election where economic policy is taking center stage, is noteworthy given central bankers' usual penchant for keeping a low political profile, particularly as both candidates say they want big changes at the Fed.
Williams, who was Fed Chair Janet Yellen’s top policy adviser when she was San Francisco Fed chief, joins a chorus of central bankers calling for stronger fiscal measures and a rethink as years of ultra-low interest rates and unconventional policies fail to stimulate breakout growth. Despite pushing rate to record lows, and over 666 rate cuts since Lehman, central bankers have been frustrated at the persistence of low growth and inflation even after years of super-easy monetary policy. What they fail to notice is that the roughly $15 trillion in de novo created liquidity has gone not into the economy, but the capital markets, where it has resulted an epic asset inflation bubble.
Williams floated two monetary policy changes to cope with lower rates: raising the Fed's current 2-percent inflation goal, or replacing its current inflation-targeting regime with some form of nominal GDP targeting. Both approaches, he said, would give the Fed more scope to lower interest rates in response to downturns. Both, however, could have costs.
Williams also called for changes to fiscal policy, advocating a more robust framework to help stimulate the economy in case of a downturn, since monetary policy will be less powerful. He floated the idea of designing “stronger, more predictable, systematic adjustments of fiscal policy that support the economy during recessions and recoveries,” such as tying Social Security benefits or income tax rates to the national unemployment rate.
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However, this is where a problem emerges.
What Williams discussed today was precisely the topic of the latest letter from DB's Dominic Konstam (who has been pounding the table for nearly one year on the topic of a near zero r-star), which we posted over the weekend, titled "A Stunning Admission From Deutsche Bank Why A Shock Is Needed To Collapse The Market, And Force A Real Panic."
In the letter, which we urge everyone to read, Konstam focused on the transition from monetary policy to fiscal policy, and emphasized that the handoff can not happen without a shock, and a "collapse in risk assets."
Here is his dramatic admission:
The status quo could continue for several years yet – if nothing “breaks” in the system. There are ways of course for either avoiding breaks or at least patching them – mitigating the impact of negative rates on banks is now in vogue with subsidized bank loans for on lending. And we may yet see soft forms of bank bailout still being allowed. This is similar to the use of alternative yield curves for discounting insurance liabilities.
The conclusion is that without an external economic shock it is hard to see policymakers being prepared to take dramatic, fiscal action to jumpstart the global economy and bounce it out of a financial repression defined by low and falling real yields to one that at least initially is defined by rising nominal yields through higher inflation expectations. Ironically the shock that is needed would require a collapse in risk assets for policymakers to then really panic and attempt dramatic fiscal stimulus.
The logic would also fit with the same correlation structure for financial assets - an unwind of the falling yield/rising equity market where all financial assets trade badly. In other words the end of financial repression will see price levels fall so that yields once again look attractive. For such a move to be sustainable itself requires the economic fundamentals to shift – inflation needs to be more secure against an underlying backdrop of robust real growth. Most people now understand that this is not a job for monetary policy alone. Yet the current reach for yield simply prolongs the status quo for policy disappointment.
Said simply, a fiscal policy stimulus is impossible as long as the S&P is trading at daily record highs, as there is simply no impetus for Congress - already the most polarized in history - to implement potentially unacceptable to their constituents policy, and in the process lose their jobs: "it it is still difficult to sense the urgency when equities make new highs. Policymakers aren’t used to dealing with financial repression and that unfortunately is one of the defining characteristics of stagnation."
Konstam's assessment: such a handoff could only work under the conditions of an asset price shock, read a market crash:
Ironically the shock that is needed would require a collapse in risk assets for policymakers to then really panic and attempt dramatic fiscal stimulus.
Meanwhile, the longer the Fed does nothing to break this adverse feedback loop, the greater the disconnect will get, the slower the economic growth will be, the lower the r-star, and the higher the market, all leading to an even greater crash when either the Fed or Congress finally concede and are forced to reconcile these two critical, and opposing, tensions.
Williams’s comments come ahead of next week’s symposium hosted by the Kansas City Fed in Jackson Hole, Wyoming, where Janet Yellen is expected to reiterate first Bernanke's, and now Williams' assessment of why the natural rate of interest had made rate hikes unfeasible in the current economy, and demand more fiscal stimulus... however, without admitting that assets first have to crash before this approach is pursued.
Because contrary to what the Fed may believe, one can not have their cake and eat it too. If the new Fed orthodoxy is indeed one of a major monetary and fiscal boost, it will first require much pain on behalf of asset holders, which as everyone knows, is something that Yellen will fight against.
We eagerly look forward to see how she resolves this particular paradox.