When the Federal Reserve lowered interest rates to close to zero during the financial crisis, it was an extraordinary move. The central bank had hit the limits of conventional monetary policy, leaving the recovery to sputter along with less help than it needed.
Now, with that crisis at last behind us, the Fed has begun raising interest rates, and it may be tempting to view its brush with rock-bottom rates as a once-in-a-lifetime experiment and to assume that we are entering a more normal world.
If only that were true. A new study suggests that near-zero interest rates — accompanied by a lackluster recovery — may become a common occurrence.
That’s troubling for many reasons. If the Fed can’t cut rates as much as required to fight a slowing economy, then recessions will become more common and more painful. It suggests an urgent need to reconsider how we will counter the next bout of bad economic news, preferably before it arrives. If monetary policy won’t be enough, perhaps fiscal policy will be. Certainly, this is no time for complacency.
In a nutshell, the American economy appears to have changed in a way that undermines the effectiveness of monetary policy but not fiscal policy, which may need to be wielded more actively.
All of this is the result of two broad trends. First, inflation is lower than in the past. From 1950 through 2011, it averaged around 3.5 percent. In January 2012, the Federal Reserve committed to a target of 2 percent, and actual inflation levels have been even lower.
Second, the real (inflation-adjusted) interest rate consistent with the economy operating at its full potential has fallen, a trend that the Harvard economist Lawrence H. Summers called “secular stagnation.” Most estimates suggest that this “neutral real interest rate” has dropped from around 2.5 percent to 1 percent, or lower.
Put these pieces together, and a conservative guess is that in “normal times,” the nominal interest rate — the neutral real interest rate plus inflation — has fallen from around 6 percent to 3 percent.
That creates a serious problem for the Fed. Here’s why: Most recessions can be cured by lowering rates by several percentage points. When interest rates were closer to 6 percent, the Fed could lift the economy with plenty of interest-rate leeway.
But when normal interest rates are closer to 3 percent, the Fed can cut rates only a few times, because rates can only go so low — perhaps as low as zero, maybe a tad lower. This means that in even a typical downturn, the Fed may be unable to cut rates as much as it would like.
Even worse, this limit is a far bigger problem when an economic downturn follows closely on the heels of a previous recession. Right now, for instance, the central bank’s main short-term rate, the federal funds rate, is still only three-quarters of a percent to 1 percent, because the Fed wants to continue stimulating the recovery. This leaves the central bank with very little room to respond if the economy falters. Even a minor slowdown now could require a larger rate cut than is feasible, once again leaving policy makers wishing they could do more.
This dynamic can feed on itself. The less ammunition the Fed has to blast the economy out of its malaise, the weaker and slower will be the recovery, making it more likely that the next bad shock will require the Fed to cut rates more than is feasible.
To assess these problems, two senior Federal Reserve economists, Michael T. Kiley and John M. Roberts, ran hundreds of simulations in the Fed’s large-scale macroeconomic model, evaluating how the United States would perform in response to the sorts of shocks that have historically buffeted the economy.
In one set of simulations that you might call the good old days, they set the normal interest rate at 6 percent, and then let the Fed adjust rates as economic conditions evolved. In that environment, interest rates hit zero only around 2 percent of the time. This accords with the reality that the lower limit on interest rates simply was not a problem until recently.
But times have changed. When the economists set the normal interest rate at 3 percent and let the Fed adjust interest rates as conditions warranted, rates moved down to zero percent and could not move any lower roughly a third of the time. In some of these cases, the economy didn’t need much extra punch, and so this slowed the recovery only a little. In others, it was a more telling constraint, and it took years for the economy to return to normal.
Their research paper, “Monetary Policy in a Low Interest Rate World,” which was presented at a recent meeting of the Brookings Papers on Economic Activity, explains why this is so worrisome.
The problem is that a lower bound on interest rates creates a sharp asymmetry in how the economy works: It’s relatively easy for the Fed to cool an overheating economy by raising rates. But when the economy is already cooling down, the central bank may not be able to cut rates enough to prevent a recession or to spur a strong recovery. Downturns will be deeper and more common than upswings. This means that, on average, output will be lower than it needs to be — perhaps more than a percentage point lower — and inflation will be lower than the Fed’s 2 percent target. Joblessness will be more common, particularly during slumps.
It is crucial, therefore, that macroeconomic policy adjusts to these problems before the next downturn hits.
The Fed has already been experimenting with monetary policy, but it hasn’t been enough. In the wake of the financial crisis, for example, it bought bonds in a program known as quantitative easing, cutting long-term interest rates once short-term rates were near zero. The resulting stimulus was relatively small, reducing long-term rates by only a fraction of a percentage point, and the program was politically unpopular.
The authors suggest an alternative approach in which the Fed makes up for “missing stimulus” by promising to keep rates lower, for longer periods. In their view, the Fed needs to make up for the interest rate cuts that it wishes it could have made, but couldn’t. Promising this in the depths of a downturn would offer businesses reason to be optimistic, they say, boosting the recovery. The Fed would need to keep rates low, even as inflation overshot its target.
It’s a promising approach, but would people really believe the Fed’s promises? I know a lot of central bankers, and I fear they are incapable of sitting still while inflation rises above their stated target.
Perhaps the answer lies outside the Fed. It may be time to revive a more active role for fiscal policy — government spending and taxation — so that the government fills in for the missing stimulus when the Fed can’t cut rates any longer. Given political realities, this may be best achieved by building in stronger automatic stabilizers, mechanisms to increase spending in bad times, without requiring Congressional action.
There’s an opportunity to wed this to President Trump’s desire for more infrastructure spending. Rather than building more roads today as the economy approaches full employment, we should spend more when the economy is weak and the Fed is unable to provide enough stimulus. One way that this could be done is by automatically increasing the Highway Trust Fund when the federal funds rate hits zero and perhaps ramping up spending the longer that rates are stuck there. More roads would be built when they do the most good for the economy.
This idea reverses a decades-long trend away from active fiscal policy. The general distrust of fiscal policy may well have made sense; many economists are more likely to trust the technocrats at the Fed to manage the business cycle than the election-driven politicians on Capitol Hill. But in a world of low interest rates in which the Fed is frequently hamstrung, we may not have that choice.
(The New York Times)