With interest rates at near-record lows in major advanced economies and signs of a deteriorating global outlook, there are concerns that central banks have limited room to provide stimulus in the event of a recession.

Central banks will need to consider a wider scope of policy options than in past downturns.

Negative central bank policy rates combined with asset purchases and forward guidance will continue to be relied on to support the advanced economies even more often in the future than in the past. That said, the major central banks will tailor the implementation of these policies according to local economic conditions and the health of the domestic banking sector. 

Obviously, there are limits to what can be achieved by monetary policy supports alone. Reducing interest rates deeper into negative territory will have diminishing returns and at some point, may even become counterproductive in terms of providing additional stimulus.

Fiscal policy will also be called upon to do more of the heavy lifting in the next downturn, especially in Japan and the Euro Area where central banks have limited interest rate reduction leverage.

The following two charts provide striking evidence of how the central bank policy world has changed today compared to the period of the Great Recession 2008-09. In the former period, central bank policy rates had plenty of room to decline to cushion the downturn.

In the past central banks were able to respond aggressively with a rapid series of rate cuts. For example, the US fed funds target rate was reduced by 550 bps over the course of the 2001 downturn and by 525 bps over the course of the downturn that began in 2007. 

Today, the room is extremely tiny in the US and the UK, while the room to cut interest rates has effectively vanished in the Euro Area and in Japan.

As well, the size of central bank balance sheets has dramatically increased since 2009 and has sharply escalated relative to the size of the economy.

In closing, central bank monetary policy in all of the advanced economies is already highly stimulative and interest rates are very low. The ability to once again cut rates dramatically simply does not exist at this time, even in the US.

(Click on image to enlarge)

(Click on image to enlarge)

(Click on image to enlarge)