By way of background: Someone called me the other day all wound up because some market prognosticator convinced her that a U.S. recession was right around the corner. I think I talked her down on that point. No one knows when the next recession is going to hit, there are no obvious destabilizing bubbles of which I’m aware, and the job market is percolating along at a good clip. We’re not at full employment, but we’re getting closer. As you know, the Fed is thinking about tightening. Bad idea, I’d argue, but not a sign of impending recession. The key point, though, is that we just can’t accurately call these things.
But I think I did succeed in getting her equally nervous about a different point: There is, of course, a recession out there somewhere. The problem isn’t that we don’t know where; it’s that we’re not ready for it.
There are two broad reasons why that’s true. One, you simply cannot trust our Congress to act quickly and forcefully on countercyclical, discretionary fiscal policy (“discretionary” meaning the stuff aside from the automatic stabilizers). Two, the Federal Reserve’s likely limited-firepower problem. The main countercyclical tool at the Fed’s disposal is the interest rate they control, the federal funds rate (FFR), a benchmark for borrowing costs throughout the economy. Historically, as Reifschneider’s Table 1 shows, they lowered it an average of around five percentage points in past recessions.
Well, right now the FFR is sitting at less than half-a-percent, which gives them very little room to cut. That’s the limited firepower problem and it’s the topic of Reifschneider’s paper. He argues that this concern may be overblown, at least under certain conditions. His reasoning is threefold:
- If the recovery keeps going the Fed may have time to get rates back up to a needed perch.
- For reasons I’ve discussed in other posts, that perch is lower than it used to be.
- The FFR is not their only tool. There’s also quantitative easing (buying longer-term bonds to lower longer-term rates) and forward guidance (resetting people’s expectations by telling us that they’re going to keep rates low for a long time).
Hmmm … I am not much comforted. There are a lot of “ifs” in Reifschneider’s story (all of which he is totally straight up about): if the Fed wins the monetary footrace and can get to their 3 percent funds rate target (and does so without pre-emptive rate increases — we don’t want them to break the economy now so they can more handily fix it later!); if the Fed has the chutzpah to add $3-4 trillion to their balance sheet … again; if the QE and guidance have the positive growth and jobs impacts the model says they do; if people’s expectations are truly moved by the forward guidance, which implies future Fed officials will maintain the program. Then sure, sounds good.
But I’m skeptical. The figure below, from Bloomberg News, shows a real problem for “if” No. 1. It draws a line through the “dot plots”: the Fed’s own predictions about where rates will go. The 3 percent at the end of the figure is the perch Reifschneider assumes they’ll get to before the next downturn.
The other lines at the bottom of the figure are the problem. They show market expectations of the funds rate and the fact that they’re so low creates a double problem for the Fed. First, if the markets are right, the limited firepower problem will be acute. Second, credibility. Remember, forward guidance works through market participants altering their expectations. At this point, the markets don’t believe the Fed’s projections.
Re “if” No. 3, and again, Reifschneider is forthright on this point (I found his paper to be a model of clarity and caution), there are reasons to worry about whether monetary policy really has the growth and jobs punch the model says it does. The very long period of very low interest rates in the current recovery in tandem with the fact that we’re still not at full employment and growth is still underwhelming certainly gives one pause.
I’ve long argued that monetary policy isn’t enough and what’s required is the one-two punch of monetary and fiscal together. Monetary sets the table with low rates, but absent greater demand, too few will sit down to eat, if you get my meaning.
For years, macroeconomists thought — many still do — that fiscal policy is ineffective: The lags are too long, the process is too corrupt, there are no multipliers to speak of. I don’t deny the process is screwed up, but that’s a self-fulfilling prophecy of sending politicians to D.C. who argue that government is broken and promise to keep it that way.
But the lasting damage of austere fiscal policy both here and more so in Europe should convince objective onlookers that central banks can’t carry the burden of offsetting market failures on their own. Sure, I hope Reifschneider’s optimistic scenarios are correct. But I fear they’re not and we’d be crazy not to have a Plan B.