San Francisco Federal Reserve President John Williams said on Friday that low neutral interest rates are a warning sign of possible changes in the U.S. economy that the central bank does not fully understand.

"I see this as more of a warning, a red flag that there's something going on here that isn't in the models, that we maybe don't understand as well as we think, and we should dig down deep deeper and try to figure this out better," he said during a panel discussion at the Brookings Institute in Washington.

Williams, who is a voting member of the Fed's policy-setting panel through the end of the year, has said the central bank should begin to raise interest rates soon but thereafter go at a gradual pace.

He added that the low neutral interest rate had "pretty significant" implications for monetary policy, and put more focus on fiscal policy as a response.

"If we could come up with better fiscal policy, find a way to have the economy grow faster or have a stronger natural rate of interest, then that takes the pressure off of us to try to come up with other ways to do it, like through a large balance sheet or having a higher inflation target," Williams said. "It also means we don't have to turn to quantitative easing and other policies as much."

In my view, the paper reaches five major conclusions---conclusions that I find myself broadly in agreement with:

There are many factors that influence the level of the equilibrium real short-term interest rate. Real potential GDP growth may be one factor, but the real equilibrium rate is also affected by financial conditions, uncertainty and risk aversion, financial market performance (e.g., bubbles and busts) and the degree of restraint exerted by the stringency of banking and financial market regulation.

There is little evidence supporting the so-called secular stagnation view that the equilibrium real short-term rate will persistently remain near or below zero.

The equilibrium real short-term rate is non-stationary. Thus, it will not necessarily revert back to some long-run average value.

U.S. and global markets are integrated to a significant degree. As a result, the equilibrium real short-term rates both here and abroad will tend to move together. This seems especially germane in the current environment in which very low long-term government bond yields in Europe and Japan appear to have been an important factor in pulling U.S. long-term yields lower over the past year or so.

Given the uncertainties about the current and future levels of the equilibrium real short-term rate, an inertial policy rule may lead to better outcomes. As a consequence, the process of normalization of monetary policy should proceed cautiously, with short-term interest rates more likely to rise only gradually toward the equilibrium real short-term rate.
...
My point estimate is that the longer-run value of the federal funds rate is 3 percent, well below its long-run historical level of 4 percent. At the same time, I also have little confidence about the accuracy of this specific estimate. So you see that I come out in a very similar place as the authors of this years Monetary Policy Forum paper. They suggest that the long-run equilibrium real federal funds rate might be in the range of 1 to 2 percent. Add on 2 percent inflation, you end up in just about the same place as my current long-term 3 percent nominal federal funds rate point estimate.

Accountabilityin any endeavor, including monetary policyis not about what actions have been taken. Rather, its about the results those actions achievespecifically, how well performance accords with the relevant objectives. Accordingly, my discussion of FOMC performance and plans is relentlessly goal-oriented.

My goal-oriented approach to FOMC accountability differs from the approach taken in legislation about monetary policy accountability that is currently under consideration by Congress. The Federal Reserve Accountability and Transparency Act (or FRAT Act) would require the FOMC to tell Congress and the public how the Committee plans to change the level of monetary accommodation in response to macroeconomic developments. A key element of the FRAT Act is a reference policy rule that would be intended to serve as a baseline for this communication. The rule frames accountability in terms of what choices the Committee is making, as opposed to how the macroeconomy is performing relative to FOMC objectives. In my discussion, Ill explain how this approach to accountability means that the reference policy rule in the FRAT Act would be likely to degrade, rather than enhance, the FOMCs ability to achieve its objectives.
...
To be clear, the proposed legislation allows for the FOMC to deviate from the reference policy rule. However, the legislation views deviations from the reference policy rule as being undesirable. (In particular, it requires the FOMC to provide Congress with a detailed justification for any departure from the reference policy rule within 48 hours.) My point is that this perspective is flawed, because the reference policy rule does not allow for the possibility that the natural real rate of interest varies over time.

While the expected neutral funds rate is something that may be relevant, estimating and communicating a value with any confidence would be challenging. Measuring longer-run trends is a difficult and delicate issue. Because expectations about monetary policy are important, particularly in financial markets, it may be useful for the FOMC to indicate what ranges are likely for the neutral federal funds rate. But given the uncertainties, this may be difficult and conveying a false sense of precision may prove to be counterproductive.

So, I believe, adjustments to the perceived neutral funds rate should be done with great care and discipline. They should not be done in response to the typical cyclical fluctuations in real rates. Our ability to truly assess a significant shift in the longer-term real rate is quite limited, and, in the presence of such uncertainty and measurement error, one should be careful not to confuse the public.

And I would say even if you consider our forward guidance we put in place in march, the committee indicated that even after we think the time has come to raise rates, that we think it will be some considerable time before we move them back to historically normal levels, and that reflects -- well, different people have different views, but to my mind, it in part reflects the fact that headwinds holding back the recovery do continue. Productivity growth has been slow, and of course, we need to be cautious to make sure that the economy continues to recover.

Even when the economy gets back on track, it doesn't mean that these headwinds will have completely disappeared. And in addition to that, productivity growth is rather low. At least that may not be a permanent state of affairs, but it's certainly something that we have seen in the aftermath. We'll -- we've seen it during most of the recovery. That's a factor that I think is suppressing business investment and will work for some time to hold interest rates down. These concerns and these factors are related to what economists are discussing, including secular stagnation. The committee -- you know, when it thinks about what is normal in the longer run, the committee has recently slightly reduced their estimates of what will be normal in the longer run. It -- the median view on that is now something around 3 and 3 1/4 percent, but we don't really know. But it's the same -- the same factors that are making the committee feel that it will be appropriate to raise rates only gradually, they're some of the same factors that figure in the secular stagnation.

STEVE LEISMAN: Question two is, doesn't that implicitly suggest a shallower glide path once you take off, or once Fed funds rates would begin -- when you first hike them -- wouldn't that suggest a shallower glide after the funds rate?

YELLEN: Yes, I think it does suggest shallower glide path. And what the committee is expressing here, I would say, is its forecast of what will be appropriate some years from now based on its -- the understanding that we'll develop about what are the economic forces that has been driving economic activity.

We've had a series of years now in which growth has proven disappointing. Now, members of the committee have different views about why this is likely to be true that the funds rate, when the labor market is normalized and inflation is back to our objective, may be have slightly different views on exactly why it's likely to be the case that interest rates will be little lower than they would in the longer run.

But for many it's a matter of head winds from the crisis that have taken a very long time to dissipate and are likely to continue being operative.
So some examples I would say is we have under -- many households are under going balance sheet repair. There are underwater mortgage holders, difficulties therefore in gaining access to credit, for example, through home equity lines of credit. For some that makes it difficult to finance small businesses. Mortgage credit is very difficult for those still to get without pristine credit scores.

My view is that the neutral federal funds rate consistent with trend growth is currently very low. That’s one reason why the economy is not growing very fast despite the current accommodative stance of monetary policy.  Although the neutral rate should gradually normalize over the long-run as economic fundamentals continue to improve and headwinds abate, this process will likely take many years.  In the meantime, the federal funds rate level consistent with the Committee’s objectives of maximum sustainable employment in the context of price stability will likely be well below the long-run level.

It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

An alternative policy option is to be more proactive, but cautious. This would require initiating a reversal of policy earlier in the recovery while the data are still mixed but generally positive.

Under this policy course, the FOMC would initiate sometime soon the process of raising the federal funds rate target toward 1 percent. I would view a move to 1 percent as simply a continuation of our strategy to remove measured that were originally implemented in response to the intensification of the financial crisis that erupted in the fall of 2008. In addition, a federal funds rate of 1 percent would still represent highly accommodative policy.

We know we cannot have this highly accommodative policy without risking some pretty difficult inflationary consequences. So let's deal with that.

Once we get the policy rate in a range ... around neutral -- I cannot identify what neutral is, but I know that it is not a quarter of a percentage point over a long period of time -- you stay within that range.

What we need to do is get to some level of policy that is more constrained, around a neutral level, and then let the economy work its way through.

As reported by Reuters.

I nevertheless considered the larger-than-usual cut in the funds rate prudent because of two features of the current environment. First, the stance of monetary policy before the September meeting was probably a bit on the restrictive side, at least according to many estimates of the so-called “neutral” or “equilibrium” federal funds rate. In fact, the stance of policy was growing more restrictive as core inflation gradually trended down. Second, with the economy operating near potential and inflation well contained, a case could have been made that the funds rate would need to move down toward a neutral stance, even if there had not been a financial shock.

Moskow declined to explicitly state what the ideal inflation rate or funds rate would be. "I don't want to try a number -- five and a quarter is the appropriate rate at this particular time," he said. 

From a MarketNews summary of a CNBC interview

Right now our policy rate ... is moderately restrictive. Not severely, but modestly so. And that allows for the economy to continue to grow ... and slowly, hopefully, bring down the inflation rates for CPI, the core CPI, to levels even closer to 2 percent as we move forward.

As reported by Reuters

An “asymmetric policy tilt” seems appropriate given the risks to inflation.  However, the complexities of the current situation—including uncertainties concerning the behavior of output and employment, as well as growing downside risks to economic growth and the possibility that the neutral level of the funds rate has been lowered by a productivity slowdown—make it appropriate for policy to retain considerable flexibility in responding to emerging data.  The statement thus emphasizes that “Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”  What all of these considerations add up to is that the stance of monetary policy will undoubtedly need to be adjusted in ways that are dictated by shifts in our forecasts for inflation, output, and employment in light of incoming data. 

Neutral policy would be one where there is a sense that the risks are weighted equally on both sides of the dual mandate and, therefore, policy is essentially unpredictable. It depends on events as they come forward.