A global perspective must be used to prepare for the next recession, even though it’s not on the near horizon, Federal Reserve Bank of San Francisco President John Williams said Thursday.
“Economic realities for the world’s developed economies have fundamentally changed and dealing with the challenges of the future is going to be much harder than it was in the past,” he told the Bank’s Asia Economic Policy Conference, according to prepared text released by the Fed.
Since the challenges aren’t unique to the United States, it “requires a global perspective that recognizes the interdependence of our economies and financial systems.”
While admitting his timing “may seem strange” with the economy growing and central banks removing accommodation, Williams said, “history teaches us that a recession will come at some point, and prudence demands that we use this time of relative economic calm to plan for the storms ahead.”
But the normal that economies are returning to are truly a “new normal,” with growth and interest rates much lower than typical.
The reason, he said, is “low r-star, the natural rate of interest, which is being held down by a number of structural issues largely beyond the control of central banks and monetary policy.”
Slower productivity and labor force growth play a part as does longer lifespans and increased global demand for safe assets, which lowers yields on central bank policy rates. These trends began before the recession and will not reverse soon.
With the U.S. r-star about 0.5%, given 2% inflation, the “normal short-term interest rate would be 2.5%,” 2 percentage points lower than “normal” two decades ago.
And low r-star is a global problem, with many industrialized nations below 0.5%.
If interest rates are 2% to 3% at the start of the next recession, the Fed won’t have “the typical 5 percentage points to stimulate the economy because we’ll quickly hit the zero lower bound,” forcing it to use unconventional monetary policy. This, he said, could include “forward guidance, negative interest rates, and quantitative easing.”
Williams said, “We will all be better able to contain the next economic recession if we develop approaches that succeed even when many countries are simultaneously constrained by the lower bound. And that means taking into account the nature of monetary policy spillovers.”
It is important to recognize the economy’s global nature and plan “a framework and strategies that work well together, rather than at cross-purposes.”
While the best option to prepare for a recession are fiscal and other policies to “propel long-run economic prosperity and boost r-star on a sustained basis.” But, Williams said he fears “those changes may not arrive soon enough, if at all.”
Using unconventional tools is another option. Another possibility is “to find ways to make the lower bound more negative, giving conventional monetary policy more room to maneuver. A third is to raise the inflation target. And fourth is to modify inflation targeting by moving to a price level or nominal income target,” he said.
All these options have “significant advantages and disadvantages, which need further careful study and discussion.”
Williams said his purpose is to boost the conversation since some of these approaches have yet to be used.