The Federal Reserve’s recent turn toward patience on further rate hikes underlines an unfortunate reality: the central bank will have way less ammunition to fight the next recession than it had in the past.
“The apparent change in monetary policy strategy led some observers to ask whether the Fed is overreacting to recent market volatility,” Tiffany Wilding at Pacific Investment Management Co. LLC wrote in a blog post. “Many Fed officials now see a good chance that the current range of the fed funds rate (2.25 per cent to 2.5 per cent) is the terminal level of this cycle — a level notably lower than most of them had previously expected.”
On one hand, the Fed is comparatively well-positioned for a downturn. Officials have lifted rates off of zero, unlike their counterparts in Europe and Japan, so they have room to cut them to boost lending. They’ve also shrunk their swollen balance sheet and have more space to pursue large-scale bond buying if the economy should really slump.
Yet the fact that interest rates are likely to linger at a stopping point well below the historical norm — whether that’s the current setting or slightly higher — means that the central bank will have less room to ease policy to boost growth.
Against that backdrop, the Fed plans to spend 2019 talking about its future policy framework. San Francisco Fed President Mary Daly suggested last week that the central bank might contemplate using bond buying as a more regular tool, not one solely reserved for when interest rates are at zero. Pimco’s Wilding suggests that average inflation targeting — basically letting prices run a little higher when the economy is strong — could also be on the menu. That’s an idea often raised by New York Fed President John Williams.
“Policy-makers could also look to create more ‘room’ to hike interest rates when times are good,” she writes. “By raising inflation expectations, or at least working to ensure expectations remain anchored at the Fed’s longer-term target” the Fed “could potentially further raise nominal interest rates over time.”
What we know for sure at this point is what the central bank has announced: the Fed will review its strategies, tools and communication practices, complete with a June research conference in Chicago. They plan to report findings at the end of the process.
A key question is whether the Fed will have time to come up with a rebooted game plan before a slowdown strikes again. Researchers at Oxford Economics say that looking at data from the U.S., U.K. and Germany and the euro area, 12 of the 22 recessions since the 1950s (1970s for Europe) came between one and three quarters after policy rates had hit their peak. That doesn’t mean that central banks cause recessions, but it does suggest that they struggle to prevent them.
Also worth watching? Whether the Fed actually thinks they’re done for the cycle. Speakers so far seem divided — many are reserving judgment. Policymaker’s next Summary of Economic Projections, scheduled for release March 20, could give us a more comprehensive clue.