I’ve written quite a bit recently about the apparent complacency of the Reserve Bank (and The Treasury and the Minister of Finance) around the ability of monetary policy to adequately cope with the next serious recession (here, here, and here).
Against that backdrop, it was interesting to see a substantive report of a recent discussion of exactly these sorts of issues in the minutes of a meeting a few weeks ago of the Federal Open Market Committee, the arm of the Federal Reserve that makes monetary policy decisions. One might reasonably suggest that the discussion is happening several years later than it should have – the problems and the limitations of conventional monetary policy have been apparent for some years now (especially in countries like the US that reached the effective lower bound in the last recession) – but better late than never. And in the US context, some individual members of the FOMC have felt free to speak openly (eg here) on the issues and some possible policy responses. It is the way open monetary policy committee systems can work.
Here are some extracts from the FOMC minutes
Monetary Policy Options at the Effective Lower Bound
The staff provided a briefing that summarized its analysis of the extent to which some of the Committee’s monetary policy tools could provide adequate policy accommodation if, in future economic downturns, the policy rate were again to become constrained by the effective lower bound (ELB). The staff examined simulations from the staff’s FRB/US model and various other economic models to assess the likelihood of the policy rate returning to the ELB and to evaluate how much additional policy accommodation could be delivered by the current toolkit.
Somewhat surprisingly, a footnote indicates that the staff modelling was still based on an effective lower bound of 12.5 basis points (the actual low the Fed went to for years after 2008), even though other countries have gone modestly negative (and our Reserve Bank has taken the view that the OCR could go to, say, 0.75 per cent. There is no hint in the minutes of the FOMC discussing a lower effective floor, or what steps might be considered to lower it.
The staff’s analysis indicated that under various policy rules, including those prescribing aggressive reductions in the federal funds rate in response to adverse economic shocks, there was a meaningful risk that the ELB could bind sometime during the next decade.
Hardly surprising, given that the current Fed funds target is 1.75-2.0 per cent, and recessions seem to come round every decade or so.
In the discussion that followed the staff’s briefing, participants generally agreed that their current toolkit could provide significant accommodation but expressed concern about the potential limits on policy effectiveness stemming from the ELB. They viewed it as a matter of prudent planning to evaluate potential policy options in advance of such ELB events. Many participants commented on the monetary policy implications of the apparent secular decline in neutral real interest rates. That decline was viewed as likely driven by various factors, including slower trend growth of the labor force and productivity as well as increased demand for safe assets. In such circumstances, those participants saw monetary policy as having less scope than in the past to reduce the federal funds rate in response to negative shocks. Accordingly, in their view, spells at the ELB could become more frequent and protracted than in the past, consistent with the staff’s analysis. Moreover, the secular decline in interest rates was a global phenomenon, and a couple of participants emphasized that this decline increased the likelihood that the ELB could bind simultaneously in a number of countries. A few other participants raised the concern that frequent or extended ELB episodes could result in expectations for inflation that were below the Committee’s symmetric 2 percent objective, further limiting the scope for reductions in the federal funds rate to serve as a buffer for the economy and increasing the likelihood of ELB episodes.
There was clearly a range of views round the table, but it was encouraging to see some members highlight a variant of a point I’ve made here: because firms, households and market participants know that central banks will have relatively more limited firepower in the next recession, it may be harder to keep inflation expectations near the target, which may compound the challenges.
In the US, high government debt and large deficits are likely to be a constraint on the scope for active fiscal policy to complement monetary policy.
Fiscal policy was viewed as a potentially important tool in addressing a future economic downturn in which monetary policy was constrained by the ELB; however, countercyclical fiscal policy actions in the United States may be constrained by the high and rising level of federal government debt.
That might be on “technical” grounds – genuine risks of bond market sell-offs – or the wider political constraints that I highlighted in my post the other day, and which are likely to apply even in less-indebted countries like New Zealand.
Participants generally agreed that both forward guidance and balance sheet actions would be effective tools to use if the federal funds rate were to become constrained by the ELB. In the Addendum to the Policy Normalization Principles and Plans statement issued in June 2017, the Committee indicated that it would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate. However, participants acknowledged that there may be limits to the effectiveness of these tools in addressing an ELB episode. They also emphasized that there was considerable uncertainty about the economic effects of these tools. Consistent with that view, a few participants noted that economic researchers had not yet reached a consensus about the effectiveness of unconventional policies. A number of participants indicated that there might be significant costs associated with the use of unconventional policies, and that these costs might limit, in particular, the extent to which the Committee should engage in large-scale asset purchases.
The uncertainties seem considerable.
The FOMC discussion concluded this way
While the Committee’s current toolkit was judged to be effective, participants agreed, as a matter of prudent planning, to discuss their policy options further and to broaden the discussion to include the evaluation of potential alternative policy strategies for addressing the ELB. Building on their discussions at previous meetings, participants suggested that a number of possible alternatives might be worth consideration and agreed to return to this topic at future meetings. Several participants indicated that it would be desirable to hold periodic and systematic reviews in which the Committee assessed the strengths and weaknesses of its current monetary policy framework.
As one reader noted in sending me the link to these minutes “refreshing (at least directionally)”, which sounds about right to me. The FOMC still seems quite a long way from really grappling with the severity of the next serious recession, when they (and all their major peer central banks) will have (it appears) little conventional monetary policy leeway, there is a great deal of uncertainty about the potential of unconventional instruments, and everyone – especially in the financial markets – will know it.
But it is to their credit that they are willing to have a discussion of this sort, publish fairly substantive minutes highlighting some important differences of emphasis and uncertainties, and are open to independent (named) perspectives from members in speeches. That said, it should disconcert people that the FOMC is not already rather better prepared for the next serious recession – like all central banks, their ability to anticipate the timing of the next such event is non-existent.
The Governor of the Reserve Bank has apparently been at the Jackson Hole retreat for central bankers this weekend. Perhaps he could compare notes with his US counterparts and come back ready for some more open and substantive engagement on these issues in a New Zealand context (after all, in a day or two, he’ll have been in office for five months and we’ve still not had a substantive speech from him on any topic the Bank is responsible for). Encouragingly, the Governor is reported as telling an interviewer in the margins of Jackson Hole that
The “biggest challenge” is to “get inflation to rise”
But it will be much more of a challenge in the next serious recession if people can’t be confident that central banks, here or abroad, can do all that needs to be done. At present, no one can reasonably be that confident. New Zealand can’t fix the world’s problems, but our policymakers can ensure our economy is well-positioned. Not doing more just because others are still not doing enough should be no more excusable than when all too many countries drifted to the limits of conventional monetary policy at the end of the 1920s. It wasn’t as if no one then was highlighting the risks.
I have a few other substantial commitments over the next two or three weeks, which means that blogging here may well be quite light for a while.
5 thoughts on “The Fed looks to options in the next serious recession”
…..tend to think financial markets know that central banks will once again do “whatever it takes” (per Mr Powell over the weekend) to prevent deflation being priced: otherwise, the forward looking folk would be causing more trouble in (credit) markets than currently observed.
But “whatever it takes” was grossly inadequate last time (look at the sluggish recoveries, weak inflation, persistent output gaps). Take your point about expectations, but I’m not that persuaded – markets and central bankers seem to be sharing the same blindspots. (And that vulnerabilities of the monetary system in the late 1920s still left most people surprised by the depth of the Great Depression and associated fall in prices.)
I’m not necessarily expecting a deep inflationary spiral, but it will be very hard for central banks in a future serious recession to keep inflation persistently above zero (the Japanese experience, and their experience of deflation was not catastrophic).
….”grossly inadequate”? given what happened Q4’08*, tend to think the abundance of liquidity did its job when you compare the subsequent outcomes relative to the Great Depression; to my mind, the recovery seems slow as the prior expansion was, with hindsight, unsustainable; those long run structural challenges have seemingly arrived and, per Mr Powell, most are beyond the reach of monetary policy; roll on the politician who has the plan to keep the engine humming….
*cue the slew of Lehman/GFC anniversary articles that will remind the market the backstop is still waiting in the wings…
But you seem to be conflating a number of things:
– policy actions in and around q408 and those over the subsequent years (to now)
– the slowdown in productivity growth (which, as you imply) was already underway pre 08 and the gaps between actual and potential output and actual and NAIRU unemployment. Monetary policy can’t do anything much about the former, but its prime job is to do something about the latter, and yet we had 8-9 years of excess capacity across the OECD (on OECD’s own estimates), and went into that downturn with lots of monetary firepower.
Re the looming anniversary articles, they will ( i suspect) highlight the institutional bailout possibilities, but also highlight the dreadful economic record in most of the West over the last decade. I hope they will also refocus attention on the risks of another serious recession and the limited firepower (as the FOMC was doing in their discussion).
….ah; my basic musing – think mon pol can still act to prevent a material downturn (i.e. a deflation mindset) but it can’t currently spark a cyclical revival as economic drivers and imbalances require political ideas/solutions (and hence, the ongoing downward revisions to potential growth rates).