Why Williams expects low interest rates to persist

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While the Federal Open Market Committee will raise interest rates a total of three or four times this year, interest rates will remain low by historical standards, Federal Reserve Bank of San Francisco President John Williams said Tuesday.

“I view this to be the right direction for monetary policy,” Williams told the Economic Club of Minnesota, according to prepared text released by the Fed.

“But even as we raise rates, I’m conscious that the fundamental drivers that govern r-star are lower than we’ve seen in the past,” he noted. “With a new normal for short-term rates of around 2.5%, interest rates are likely to remain low relative to historical experience.”

R-star is the natural rate of interest, and Williams calculates it at “around 0.5%.” If inflation runs at the 2% target, it translates into a “normal short-term interest rate” of 2.5%, he said, which is “an incredibly low level — in fact, a full 2 percentage points below what a normal interest rate looked like just 20 years ago.”

Although a number of economists and central bankers recently opined they see signs of rising r-star, Williams said, “I wish I could join in this optimism, but I don’t yet see convincing evidence of such a shift. The longer-run drivers still point to a ‘new normal’ of a low r-star and relatively low interest rates.”

William pointed to three issues — demographics, productivity growth, and the demand for safe assets — that will keep r-star holding “its position low in the sky for quite some time.”

Demographics changes include people living longer, saving more for retirement, and slowing labor force growth due to the retirement of baby boomers and low fertility rates.

Productivity growth has also slowed compared with earlier decades. While the rise in computers and the internet pushed productivity gains up to 2% to 3%, productivity gains since the recession have been near 1%, Williams said. “While I can hope we’re on the brink of another game-changing invention like the internet, for the moment, the data indicate productivity growth is still stuck in low gear.”

Global demand for safe assets has increased in the past 20 years, he said. “This has driven down the returns on Treasury securities and safe short-term loans relative to those on riskier assets … and thereby depressed r-star.”

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Monetary policy John Williams Federal Reserve Federal Reserve Bank of San Francisco FOMC
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