By Ann Saphir and Howard Schneider
PALO ALTO, Calif., May 5 (Reuters) - Federal Reserve policymakers fear they are ill-equipped to battle the next recession under their current inflation-targeting approach, and this year are well into an effort to vet new strategies for managing interest rates in a world of muted inflation and low borrowing costs.
But for the U.S. central bankers and monetary policy experts who converged in Palo Alto Friday to discuss available options, the challenge was clear: not only will it be difficult to settle on a better framework before the next recession hits, figuring out how to explain it to the public so that it actually works will be a major challenge.
Indeed, just to explain their ideas to each other, Fed policymakers and academics at the Hoover Institution's annual conference displayed slide after slide crammed with equations, lengthy bullet points, and nearly indecipherable charts.
And while most of the PhD economists in the audience presumably understood the theories, "I think where people disagree is, do the assumptions of the model really play out in real life?" Cleveland Fed Bank President Loretta Mester said in an interview on the sidelines of the conference.
In other words, what will really work?
When central bankers around the world reached for unconventional tools like bond buying and forward guidance to fight the 2007-2009 financial crisis, they thought they were facing once-in-a-lifetime conditions.
But a decade on from the end of the Great Recession, it's clear the Fed is dealing with a new economic norm. Neither inflation nor interest rates are expected to rise much even with U.S. unemployment at a near 50-year low.
That leaves the central bank with much less leeway to cut interest rates to stimulate the economy than it historically has had.
So this year, with the U.S. economy on an even keel, interest rate policy on pause, and an expansion set to reach record length this summer, Fed policymakers figure they have a bit of breathing room to figure out how to make policy more effective when the next recession or shock comes along.
Among the ideas: commit to making up for bouts of low inflation with periods of above-target inflation; rely on simple policy rules to take the guesswork out of rate decisions; and use negative interest rates to force businesses to invest and banks to lend during downturns.
SHOCK ABSORBERS FOR A NEW WORLD
All would, their advocates say, act as shock absorbers to cushion economic weakness and shorten recessions.
Each would differ, to greater or lesser degrees, from the Fed's current approach, by which it aims for 2 percent inflation and a loosely defined ideal of full employment.