How Low Can You Go: Monetary Policy Constraints And Options For The Next Recession

This is the longest U.S. economic expansion ever. And while expansions don’t die of old age, it’s prudent for investors and central bankers to think now about the potential consequences of the next global recession. To put it bluntly, the next five years are likely to prove very challenging for monetary policymakers. Slowing demographic trends, lackluster productivity growth and other factors have conspired to depress the level of real interest rates relative to decades past.1

(Click on image to enlarge)

Chart of neutral interest rate

An immediate consequence of secularly lower neutral interest rates is that central banks are more likely to find themselves constrained by the zero-lower bound—which occurs when the short-term nominal interest rate is at or near zero—during an economic downturn. For example, if we overlay the policy space that has historically been required by the U.S. Federal Reserve (the Fed) to fight booms and busts, we find the Fed would likely need to cut rates below zero in the next recession to provide a normal degree of policy accommodation. In the chart below, you’ll see that the lower pale blue band of normal policy space is in negative territory.

(Click on image to enlarge)

Normal recession rate levels

Using more sophisticated econometric techniques, two researchers from the Federal Reserve Board in Washington, D.C.,2 have suggested that the effective lower bound on interest rates could bind 40 percent of the time going forward. That’s a big deal. It means that tools like zero interest rates, forward guidance, and quantitative easing—often considered an extraordinary response to the Global Financial Crisis—are likely to be the new normal. Furthermore, the challenges of the zero-lower bound suggest that future economic recoveries, all else equal, are likely to be more protracted. And fiscal policy will need to play a larger countercyclical role.

This leaves us with three questions:

  1. How the Fed is approaching this important issue right now?
  2. What is the range and efficacy of the options global central banks have at their disposal, should the global business cycle rollover?
  3. What are the implications for investors?

 In short, the answers are “they’re thinking about it,” “limited” and “big”.

The Fed’s approach—research!

The good news is that we aren’t raising anything in this note that central bank chiefs don’t already know. Vice-Chair Richard Clarida is spearheading the Fed’s review of this issue. He’s highlighted three fundamental research questions:

  • Should the Fed be satisfied with 2% inflation, or should it seek to also make up for past misses?
  • Are existing policy levers adequate for the next recession? If not, how can the toolkit be expanded?
  • How can the Fed’s communication with the public be improved?

The first research conference on this topic was already held at the Federal Reserve Bank of Chicago on June 4 and 5. And an army of Ph.D. economists across the Federal Reserve System are doing their own homework in parallel to that. The Fed’s conclusions from this review are scheduled to be shared with the public in early 2020. If you’re a glutton for punishment, feel free to comb through the papers and speeches already published on this matter, such as these by BernankeYellen, and Williams. Our fingers are crossed that central bankers will get this problem sorted out before the next recession hits. And while the Fed faces challenges, the European Central Bank and the Bank of Japan are at even greater risk, should they go into the next recession with no scope to meaningfully cut overnight interest rates.

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Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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