With the economy recovering, now is the time to reflect on monetary policy framework and strategy and seriously consider flexible price-level targeting, Federal Reserve Bank of San Francisco President John Williams said Friday.

“Although an inflation targeting framework has served central banks across the globe well in the past, the world has changed in ways that call into question its efficacy going forward,” Williams said at the Shadow Open Market Committee meeting in New York.

Since it is impossible to “predict precisely when or where the next storm will arrive, or exactly what it will look like,” becoming resilient allows “[you to be] ready and able to limit the damage and recover quickly,” he said.

Federal Reserve Bank of San Francisco John Williams.
Federal Reserve Bank of San Francisco John Williams. Bloomberg News

“We need to think of our resiliency toward the next economic storm in the same terms.”

With the natural rate of interest, or r-star, at historic lows, it “hampers” conventional monetary policy’s response to economic shocks.

Williams said a successful monetary policy framework is based on “adaptability, accessibility, and accountability.

“By this I mean that effective strategies should be able to adapt to change in an uncertain world. They should be accessible and transparent so that the public can plan and act in accordance with the strategy. And they should facilitate accountable benchmarking and performance measurement,” he said.

“Underlying constants like potential GDP, the natural rate of unemployment, and the natural rate of interest are not really constant: They change over time in unpredictable ways,” he continued. “Monetary policy has proven most successful when it has been able to account for these changes."

Williams and Athanasios Orphanides investigated a policy strategy closely related to a version of the Taylor rule, but with policy responding “to deviations of the level of prices relative to a steadily growing target level, rather than deviations of the inflation rate from a target rate.” They found a strategy targeting the price level this way, responding to the “unemployment rate can be highly effective at stabilizing both inflation and unemployment in an environment of structural change and uncertainty.”

Changes in inflation are “made up,” so, “over the medium term, inflation stays on track, even if policymakers have a very imperfect understanding of the levels of natural rates or other structural changes affecting the economy.”

One possible drawback to a price-level framework is it will only work “if it is followed consistently over time and well understood by the public,” Williams said, It will not work as a short-run “fix” for the low r-star problem.

Another shortcoming is “it may not be sufficient to deal with a very low r-star world without other complementary policy actions, whether in fiscal or monetary policy,” he said.

Because “r-star will remain low for the foreseeable future,” the Fed must “assess the pros and cons of alternative frameworks and strategies."

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