Macro Weekly – More exciting than the Olympics?1

by: Han de Jong

  • Future monetary policy on agenda Jackson Hole…
  • With focus on monetary policy during the next recession…
  • The natural rate of interest: fact or fiction?…
  • And monetary policy and other policies
Macro-Weekly-19-August-2016-1.pdf (95 KB)

Central bankers from around the world, accompanied by leading academics will gather this Thursday in Jackson Hole, Wyoming for their annual Economic Symposium, organised by the Kansas Fed, usually simply referred to as Jackson Hole. For central bankers and central-bank watchers this meeting can be very interesting and of significant importance. The proceedings regularly impact on how economists look at the world economy and monetary policy in particular as policy intentions and shifts are often implicated in the speeches. The Fed chair usually talks and financial market participants often get some clues about policy direction in the months ahead. Famously, Mario Draghi implicitly announced the ECB’s QE programme at the Jackson Hole conference in 2014 as he said some things that even his speech writers did not know he was going to say.

Jackson Hole’s topic this year is “Designing Resilient Monetary Policy Frameworks for the Future.” My guess is that not too many people will immediately think this promises to be more exciting than the Olympics, but it really does, trust me.

While some of the discussions may focus on the immediate outlook for US monetary policy, I think the question at hand is what monetary-policy makers can and will do over the medium term. Why is that an important and relevant question?

When the next recession starts

It is fair to say that monetary policy has played and is still playing a crucial role in trying to bring the economy back onto a sustainable growth path with low, but positive inflation. One can argue how successful and effective all these policies have been so far. In any event, we must acknowledge that interest rates are extremely low. The US economy is seven years into its recovery. This is already the third longest recovery period since WWII (see table) and it will soon be a contender for at least the silver medal. Yet, the Fed has only raised its key policy rate one time.


Recoveries don’t die of old age, they die because of a shock, policy mistakes or unsustainable bottlenecks in the economy choking economic activity. For now, I can’t see any of these any time soon. But one thing is certain, a recession will occur at some stage. And if you look at the numbers in the table, you could conclude that a recession is likely within the next few years. If US monetary tightening continues at its current (snail) pace, interest rates will still be very low when the next recession sets it. This limits what the Fed can then do with traditional monetary policy to support activity. So it seems wise to develop a plan and I think that is what the conference is all about.

John Williams’ contribution

San Francisco Fed President John Williams recently made a valuable contribution to this discussion2. I think his line of argument is likely to be followed by many others. He first explains why interest rates are low and possibly very likely to stay very low for a long time. His basic assumption is that there is a level of interest rates, usually referred to as the ‘natural rate’, which he defines as the rate at which monetary policy is ‘neither accommodative nor contractionary in terms of growth and inflation’. Unfortunately, we do not know where this rate is. But if growth and inflation are below target, one must assume that actual interest rates are above the natural rate and if growth and inflation are higher than is considered desirable, actual interest rates are likely to be lower than the natural rate. Williams’ whole subsequent argument is based on this idea. Most economists accept this assumption about the natural interest rate, but it is possible to take a different view. Economists who reject Williams’ assumption can arrive at radically different policy advice. It is interesting to see if, for example, Austrian-school thinkers will be represented at Jackson Hole.

While we can not be sure about the level of the natural interest rate, we can be sure that it moves around over time as it is dependent on, among other things, the potential growth rate of the economy. Over the last quarter century, the potential economic growth rate appears to have declined almost everywhere and so must have the natural rate of interest. Academics and central bankers try to quantify where the natural rate of interest is. Together with some Fed-colleagues, Williams has estimated that the natural rate of interest, corrected for inflation, was around 3% in 1980 in the US and the eurozone, but has since fallen to below 1% in the US and below 0% in the eurozone.

Low trend growth, for how long?

On the issue of trend growth, Williams assumes it will remain very low for a long period. That may, or may not be correct. He refers to the discussion on ‘secular stagnation’. The idea that trend growth will be very low for a long time may be correct and I understand the underlying considerations, but the optimist in me says that it must be wrong. The technological development we are seeing is spectacular in many areas in my view and this is bound, sooner or later, to raise productivity growth and thereby trend growth of the overall economy. The discussion on secular stagnation is a prime example of how economists often work. They are completely surprised by a certain development they did not forecast. When that particular development is undeniably there, economists try to rationalise it by coming up with explanations. In that process they convince themselves so much of the validity of these explanations that they assume these things can never change again. But never mind that…let’s assume Williams is right until proven otherwise. Conclusion: the natural rate of interest is very low and will continue to be very low.

As inflation has also fallen, it is no surprise that actual interest rates are as low as they are. In order to provide short-term stimulus to the economy when needed, central banks must push the actual market rate below the natural rate. In the case of the eurozone, that would be below zero in real terms, and as inflation is currently around zero, it means the ECB must push actual interest rates below zero to provide stimulus if it deems it necessary to do so. And that is precisely what the ECB is doing. Again, it is possible to disagree with this whole line of argument.

There is a limit to how negative actual interest rates can go. If actual interest rates cannot fall below the natural rate, traditional monetary policy becomes impotent. Williams argues that it is wise to think about what the policy response to a recession should be under such circumstances.

How to overcome the central bank’s impotence

His answer has two elements. First, he argues that policymakers must try to raise the trend growth rate of the economy, mainly by investing in education and infrastructure. I always think that advocating investment in infrastructure and education is like advocating that people should brush their teeth; it is hard to see how one can be against it. But political reality has to be considered and I don’t think simply raising spending on infrastructure and education will solve all our problems. It is true, however, that public spending on infrastructure was cut back sharply in many countries when governments pursued austerity policies. By doing so they were obviously putting the horse behind the cart.

Williams second policy advice is to use fiscal policy more actively to stabilise the business cycle. The problem here is that policy is set by politicians who may have different agendas. Williams appears to suggest this problem can be overcome by building more and larger automatic stabilisers. I personally think this is a very interesting suggestion and I am sure it will be discussed at Jackson Hole. But I also think that it will be a long and complicated process to come to such revolutionary initiatives.

Last, Williams suggests that central banks could raise their inflation target. If they then succeed in pushing inflation up, the natural rate of interest, before inflation, goes up as well and traditional monetary policy finds much more room for manoeuvre. This is an idea first launched by Olivier Blanchard in 2010. It is an interesting suggestion in my view, but the problem is how you can credibly raise your inflation target if you fail to achieve your current, lower target. This obviously has to work through inflation expectations, but raising your target alone will most likely not suffice. And this is a strategy a central bank can probably only have one shot at before it completely loses its credibility.

In a four-page contribution to the discussion, Williams obviously cannot flesh out all the details of what he is suggesting. So I am looking forward to the papers and reports on the discussions of this week’s Jackson Hole’s symposium.


1 When, … no, let me rephrase that: if you reach the end of this commentary, do not feel guilty if you prefer to see Usain Bolt in action. I am OK with that although I prefer Dafne Schippers, or Sanne Wevers, particularly with Hans van Zetten providing TV commentary and analysis.

2 John C. Williams, “Monetary Policy in a Low R-star World”, in FRBSF Economic Letter, 15 August 2016