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The Fed Is Back in Its Pre-Recession Pickle

The Fed Is Back in Its Pre-Recession Pickle

Officials are confronting a different kind of late-cycle economy, but resorting to the same old toolkit. By Conor Sen Source: Bloomberg.com T

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Officials are confronting a different kind of late-cycle economy, but resorting to the same old toolkit.

By Conor Sen

Source: Bloomberg.com

The Federal Reserve has had its share of drama over the past 12 years, during a credit bubble, bust and recovery. This prompted emergency measures like quantitative easing, followed by a ballooning balance sheet that is now starting to shrink. Yet despite all that drama (and some cast changes), the Fed finds itself back in the same box it was in during the middle of the last decade. This suggests a structural limitation on the institution’s power, with no clear remedy.

That “box” is the quandary of how the Fed should respond to the dynamics of late-cycle economic expansions. As in the middle of the last decade, the Fed is concerned about an overheating economy. Back then, the fear stemmed from the booming housing sector. (Now the concern is a labor shortage — with increased immigration politically unlikely and with the unemployment rate already down to 4.1 percent, below the Fed’s longer-run projection of 4.6 percent.) Financial conditions were very loose, making the Fed think that overheating risks would become even more pronounced in the future.

And back then, the Fed had a yield curve conundrum, where longer-term interest rates were anchored at a low level — perhaps attributable to global or structural reasons outside of the Fed’s control — while short-term interest rates were rising rapidly as the Fed responded to economic and financial conditions by raising the federal funds rate. Increasing short-term interest rates with little change in longer-term interest rates was quickly “flattening the yield curve,” with an inverted yield curve — short-term interest rates in excess of longer-term interest rates — being a harbinger of recession.

The yield curve inverted in the last cycle in early 2006, around the same time that housing market activity was peaking, and less than two years before recession began. With the Fed likely to raise interest rates in December, and then perhaps another three or four increases in 2018, the yield curve could invert this time around as soon as the second half of next year.

Fed officials have to be getting uncomfortable as they face this reality. In the last cycle, they managed to increase short-term interest rates as high as 5.25 percent, with longer-term interest rates getting as high as 5 percent, which gave them plenty of room to cut interest rates in recession, until hitting the zero lower bound. This time around, 30-year interest rates have struggled to stay north of 3 percent, and it’s possible the yield curve could invert with short-term interest rates only getting as high as 3 percent, with perhaps longer-term interest rates around 2.5 percent. This would be an unwelcome development for an institution concerned about how much room it has to cut rates when a downturn inevitably comes.

And yet, given their institutional mandate and the way they view the world, it’s not clear they have much choice. Fed officials apparently still favor the version of the Phillips Curve that suggests lower and lower levels of unemployment will eventually put undesired upward pressure on inflation. Economic growth remains high enough to continue to put downward pressure on the unemployment rate. They want to tighten financial conditions. And they believe their primary way of tightening financial conditions is by increasing short-term interest rates.

If fiscal policy were looser, which it might become if something like the Republican tax bills becomes law, that could put upward pressure on inflation and allow interest rates to rise further, giving them more room before hitting the zero lower bound in recession. But fiscal policy is not a tool the Fed has at its disposal, so it must act with the evidence in front of it.

Perhaps the Fed needs a rethink on some of the ways it conducts its business. Maybe it should try to target longer-term interest rates more directly — by selling assets on its balance sheet more quickly, for example. Maybe it should try more creative ways of targeting financial conditions other than increasing short-term interest rates. Maybe a 2 percent inflation target is too low and should be raised. However, it doesn’t seem like any of those things will occur until after another downturn. So the Fed will enter the next one essentially unarmed.