Imagine the US economy evolves over the next 12 months like this:
For all intents and purposes, this scenario ought to be the definition of success for the Fed. This is a monetary policy endgame for this business cycle which frankly “works.” The economy settles around full employment, and inflation settles around the Fed’s established target. Neither risky assets nor Treasurys exhibit bubble-like pricing or “financial instability.” This scenario is theoretically achievable, and in the absence of a negative external shock, could represent a reasonable base-case if the current status quo is maintained over the next 12 months. Right, all set then!
So what, if anything, is wrong with this view of the future? First, it’s not clear that the Fed would view this outcome as a success, even though it satisfies their statutory dual mandate precisely. I think there is some justifiable mandate creep, which involves integrating broad and sustainable prosperity throughout the economy into their policy goals. The demographic and distributional realities of income and wealth in the US have broken the historical link between employment, inflation, and inclusive prosperity. Right now, inflation is muted, unemployment is low, average wages and incomes are growing modestly, and yet, quality of life for most American households is still declining. If, a year from now, the statutory nirvana outlined above is achieved by the Fed, the lack of inclusivity in what modest growth is available will, if recent trends and theory hold, be worse than what we have today. Though the Fed affirms they alone cannot take decisive action to address declining median living standards, this outcome would still be unwelcome, especially since the asset-price-inflationary effect of quantitative easing continues to shoulder some of the blame for worsening inequality.
Secondly, the scenario outlined above implies that the end of the business cycle will arrive, sooner or later, with monetary policy rates around 1%; low, but still 3 hikes above where they are now. This assumption, together with inflation at 2% target, implies that the equilibrium policy rate which balances the Fed’s dual mandate (“r-star”), is a minus 1% real rate. Though this remains my core fundamental view and is already reflected to a degree in the interest rate market, the Fed doesn’t like to publicly acknowledge that the terminal rate for this policy cycle could be that low. In San Francisco Fed President John Williams’ otherwise trenchant essay entitled “Monetary Policy in a low R-star World,” he doesn’t go as far as to suggest that r-star might still be below zero in real terms. In Chair Yellen’s August 26 Jackson Hole speech, she chose to cite research from David Reifschneider, in which policy responses to a recession are contemplated when the initial Fed funds rate is “only 3%,” implying that level was already conservatively low. So while the above scenario fulfills the dual mandate, their available policy tools to fight the next recession are being rightfully questioned, particularly now that markets can envision an endgame where the terminal rate ends up being as low as 1.0-1.5%. For now, the US policy playbook at the zero lower bound consists only of quantitative easing and forward guidance. Even in the Reifschneider simulation with a 3% initial Fed policy rate, QE and forward guidance are still called upon to substitute for some 600 basis points of theoretical rate cuts which cannot occur at the zero lower bound. If the initial rate were lower than 3%, then QE and forward guidance would need to do even more heavy lifting.
Given that QE plays an uncomfortably critical role in the current policy response under scrutiny, and that it also likely contributes to deficient inclusivity in the economic recovery, the Fed may feel pressure to attempt to address both, even though it breaks their narrative on the need to raise rates as modest growth progresses.
In his essay, Williams suggests automatic fiscal stabilizers, which would formulaically raise and lower government expenditure in response to recessions and booms, respectively. Intriguingly he also suggests targeting nominal GDP or raising the inflation target to something higher than 2%, which if achieved would have the effect of allowing real policy rates to stretch deeper into negative territory at the nominal zero lower bound. Alternatively, the Fed could overtly allow inflation to exceed its target for a protracted period during the recovery in a low r-star world. While these ideas are typically relegated to “subjects for research,” to the extent the scenario plays out realistically as outlined above, the limits of current policy in a low r-star world becomes a practical problem.
My expectation is that if it appears the economy is on course to achieve the outcome discussed here, that some version of John Williams’ suggestions (I’m calling it the “Williams Doctrine” or WD for short) will be authentically debated and incorporated into policy. Whether it works or not, both to foster sustainable, inclusive growth and to give the Fed added policy flexibility, depends on whether there is sufficient demand to create inflation pressure in excess of 2%.
 We discussed the math behind it here: Oh Great, Now This: Part II.