John C Williams: Monetary policy strategies for a
low-neutralinterest-rate world
Remarks by Mr John C Williams, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the 80th Plenary Meeting of the Group of Thirty, Federal Reserve Bank of
New York, New York City, 30 November 2018.
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As prepared for delivery
I would like to start by thanking Tharman for the invitation to participate in this panel of esteemed
current and former policymakers. I am also pleased to continue the long tradition of hosting the
Group of Thirty at the Federal Reserve Bank of New York and very much look forward to this
morning's discussion.
In my remarks, I will focus on the following question: What long-run monetary policy strategy is
best suited to anchor inflation expectations, foster price stability, and promote maximum
employment? I emphasize the phrase "long-run" because I will focus on the features of a
systematic policy framework, rather than tactical policy decisions. This topic is not only of
academic interest: As was recently announced, the Federal Reserve is embarking on a review
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of its long-run monetary policy framework. I will argue that the global decline in the neutral rate
of interest over the past quarter century poses significant challenges to maintaining
wellanchored inflation expectations in a standard inflation-targeting regime. I will then lay out some
alternative policy strategies that have the potential of providing a solid anchor for inflation
expectations-even with a very low neutral interest rate-while preserving broad continuity with
current inflation-targeting practice. Now that I am already way out on a limb, I should emphasize
that my remarks reflect my own views and not necessarily those of the Federal Open Market
Committee or anyone else in the Federal Reserve System.
As a starting point, it's useful to travel back in time to the 1980s and 1990s, when inflation
targeting was introduced. The problem at the time was high and variable inflation that contributed
to macroeconomic instability and unmoored inflation expectations, which in turn fueled high and
variable inflation. To break this vicious cycle, numerous central banks instituted inflation
targeting, or variants thereof, with a focus on bringing inflation down to a low level and fostering
the establishment of stable, well-anchored inflation expectations.
This strategy worked extraordinarily well in the decade preceding the global financial crisis, as
central banks were able to achieve remarkably low and stable inflation, leading to a positive
feedback loop between low inflation and well-anchored inflation expectations.
Today, we face an altogether different set of problems stemming from a very low neutral interest
rate-that is, the short-term real interest rate consistent with an economy operating at its
potential alongside low and stable inflation. Ironically, the problem we need to solve these days is
the risk of inflation that is persistently too low, rather than too high.
Today's low neutral interest rates reflect the culmination of trends extending back 25 years. A
quarter century ago, a typical estimate of the neutral rate in the United States was 2 or 21⁄2
percent-consistent with historical averages over the preceding half century. Since then,
however, there has been a clear downward trend in neutral interest rates in the United States and
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other advanced economies, with current estimates ranging from 0 to 11⁄2 percent.
Three main global trends appear to account for the bulk of the decline in the neutral rate over the
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past quarter century. One is demographics: populations are aging as people live longer and
birth rates have fallen. The second is productivity growth, which has slowed around the world.
The third is the heightened demand for safe and liquid assets, which has led to a wider wedge
between yields on safe government securities or central bank reserves and yields on riskier
assets such as corporate bonds.
Importantly, the onset of these trends preceded the global financial crisis and they have
continued even as countries have recovered. Although there is a great deal of uncertainty about
the neutral rate, and conditions may change, a reasonable assumption is that it will remain low-
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not far from current levels-for the foreseeable future.
What does a low neutral rate mean for monetary policy and the anchoring of inflation
expectations? When a recession hits, central banks may not be able to reduce interest rates
well below their neutral level to stimulate the economy as warranted because of the effective
lower bound on nominal interest rates. This shortfall of monetary accommodation would result in
less desirable economic outcomes during the recession and recovery. In particular, inflation
would typically undershoot its desired target during these episodes. The persistence of
belowtarget inflation rates in many advanced economies over the past decade is a testament to this
dynamic.
As a result of the inherent asymmetry introduced by the lower bound on interest rates, an
inflation-targeting central bank could experience inflation that is below target, once we consider
the average inflation rate over periods when policy is constrained and those when it is not. With
inflation on average below the target level, inflation expectations will likely slip below the target
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rate as well.
A simple example helps illustrate this problem. Say that 80 percent of the time, the lower bound
on interest rates does not constrain policy and the central bank aims for a 2 percent target
inflation rate. During these "good" times, an inflation-targeting central bank aims to keep inflation
near 2 percent. But, 20 percent of the time, the economy falls into a recession that's severe
enough that the lower bound constrains policy. Assume that during these periods, inflation
averages only 1 percent. So, 80 percent of the time inflation averages 2 percent and 20 percent
of the time inflation averages 1 percent. The resulting average rate of inflation is about 1.8
percent. As a consequence, inflation expectations are likely to become anchored at the long-run
average of 1.8 percent, below the desired 2 percent target.
But, that's not the end of the story. This downward shift in inflation expectations has a
secondround effect on real interest rates, the economy, and inflation. When policy is constrained by the
effective lower bound, the downward shift in inflation expectations raises the real interest rate,
further diminishing the degree of monetary stimulus, making the downturn worse and reducing
inflation even more. Even in times when policy is not constrained, the expectation of
belowtarget inflation in the future affects current decisions, putting additional downward pressure on
inflation. In other words, monetary policy is always swimming upstream, fighting a current of
toolow inflation expectations that interferes with achieving the target inflation rate.
A number of alternative monetary policy frameworks have been proposed that aim to tackle the
problems associated with the lower bound on interest rates. Although they differ in many ways, it
is useful to divide these proposals into three broad categories. The first option is to maintain the
basic framework of inflation targeting and to rely on a combination of aggressive conventional
and unconventional policy actions when facing economic downturns to limit the deleterious
effects of the lower bound. This carries with it the risk that inflation expectations become
anchored at too low a level.
The second option is "average-inflation targeting," whereby the central bank purposefully aims to
achieve an above-target inflation rate in "good" times when the lower bound is not a constraint.
Properly designed and implemented, such an overshoot can offset the inflation undershoot
during "bad" times so that the longer-run average inflation rate and inflation expectations are in
line with the target.
The third option is price-level targeting, including its various offshoots, such as nominal GDP
targeting and temporary price-level targeting. In such a regime, the central bank commits to
keep the price level near a steadily growing target path. Like average-inflation targeting, this
strategy promises to overshoot the target inflation rate in "good" times to make up for the inflation
undershoot when policy is constrained.
In theory, both average-inflation and price-level targeting can solve the problem of anchoring
inflation expectations at the target rate while maintaining a low inflation target rate amid low
neutral rates. Although price-level targeting is a bigger leap from inflation targeting than
averageinflation targeting, each can be implemented in ways that are very similar to standard inflation
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targeting, either in terms of forecast-targeting or a policy rule. Importantly, neither will likely be
effective in practice unless communicated clearly and carried out consistently over time. More
broadly, all of these proposed strategies face potential costs and benefits-in terms of
macroeconomic performance, communication, and robustness to uncertainty-which require
careful study.
In considering alternative monetary policy strategies, academic experts, policymakers, and
others from around the world have an important part to play, sharing and discussing ideas and
comparing experiences to help all of us to think through these issues. This process of careful
study and discussion proved highly valuable during the development and implementation of
inflation targeting in decades past, and will be equally valuable in the present debates.
Thank you.
1
See Federal Reserve to review strategies, tools, and communication practices it uses to pursue its mandate of
maximum employment and price stability, November 15, 2018.
2
Shigeaki Fujiwara, Yuto Iwasaki, Ichiro Muto, Kenji Nishizaki, and Nao Sudo, Developments in the Natural Rate
of Interest in Japan, Bank of Japan Review 2016-E-12 (October 2016); Kathryn Holston, Thomas Laubach, and
John C. Williams, Measuring the Natural Rate of Interest: International Trends and Determinants, Journal of
International Economics, Volume 108, Supplement 1, pp. S59-S75 (May 2017); Thomas Laubach and John C.
Williams, Measuring the Natural Rate of Interest Redux, Business Economics, Volume 51, Issue 2, pp. 57-67
(July 2016); John C. Williams, Monetary Policy in a Low R-star World, FRBSF Economic Letter 2016-23 (August
15, 2016).
3
Carlos Carvalho, Andrea Ferrero, and Fernanda Nechio, Demographic Transition and Low U.S. Interest Rates,
FRBSF Economic Letter 2017-27 (September 25, 2017); Marco Del Negro, Domenico Giannone, Marc P.
Giannoni, and Andrea Tambalotti, Safety, Liquidity, and the Natural Rate of Interest, Brookings Papers on
Economic Activity, Spring 2017.
4
John C. Williams, The Future Fortunes of R-star: Are They Really Rising? FRBSF Economic Letter 2018-13 (May
21, 2018).
5
Thomas M. Mertens and John C. Williams, What to Expect from the Lower Bound on Interest Rates: Evidence
from Derivatives Prices, Federal Reserve Bank of New York Staff Report No. 865 (August 2018).
6
John C. Williams, Preparing for the Next Storm: Reassessing Frameworks and Strategies in a Low R-star
World, FRBSF Economic Letter 2017-13 (May 8, 2017).