The global economy is slowing, U.S. business investment has stalled, and the yield curve, which reflects market expectations of future interest rates, has inverted—a quirk that preceded previous recessions. How should monetary policy respond?
The Federal Open Market Committee, of which I am a participant, will consider this question at our September meeting. Absent some surprise reversal in these economic developments, I will argue that we should not only cut the federal funds rate, but that we should also use forward guidance to provide even more of a boost to the economy than a rate cut alone can deliver.
The Federal Reserve’s traditional monetary policy tool is the federal funds rate, an overnight interest rate that banks charge each other. Consumers and businesses, by contrast, care about long-term rates, because when a family buys a house or a business builds a factory, they take out a long-term loan.
For most of us, it’s that longer interest rate that counts. But, because long-term loans are like a series of short-term loans, movements in the overnight rate (especially those seen as long-lasting) tend to move long-term rates. So by adjusting the overnight rate, the Fed can influence long-term rates and affect investment in the real economy.
After the Fed lowered the federal funds rate to near zero during the financial crisis, many people asked if it had left itself without ammunition; overnight rates were then about as low as they could go.
That’s when the Fed turned to two new tools, quantitative easing and forward guidance, to provide more stimulus. By buying long-term Treasury bonds and mortgage-backed securities in its quantitative easing programmes, the Fed pushed down long-term rates, which provided more stimulus.
Forward guidance can also provide stimulus by signalling that overnight rates will be low in the future. For example, the federal funds rate effectively hit zero in late 2008, but the rate on a 10-year Treasury bond stood at 3.5 per cent for much of 2009, in part because investors assumed rates would pick back up.
If the Fed had made a firm commitment to keep overnight rates at zero for the next 10 years, the 10-year Treasury rate would likely have been close to zero. So the Fed can also influence long-term rates by giving guidance about the future path of their short-term equivalents. The firmer the Fed’s commitment, the more influence it can have.
Forward guidance was a new and untested tool during the financial crisis, so the Fed implemented it conservatively. Critics of these tools feared high inflation and a devalued currency, but such risks did not materialise.
The question now is: “When should we use them?” Conventional wisdom says only after the federal funds rate has been lowered to zero. Once the traditional tools are worn out, turn to the new ones. But this view is mistaken; forward guidance should be used now, before the federal funds rate returns to zero.
If a central bank cuts rates to zero in response to a downturn and then announces that it plans to keep rates low, that can actually be perceived as a sign of weakness rather than strength. Market participants understand it is the economy keeping the rate low, not the central bank choosing freely. It’s like driving a car into a ditch and then declaring you are staying there by choice. The reality is you can’t get out. It is better to avoid it in the first place.
If the global economy continues to weaken and the trade war between the U.S. and China intensifies, the Fed could find itself cutting rates aggressively. It would be better to deploy guidance now in an effort to avoid hitting zero.
What would such guidance look like? At a minimum, we should commit to not raising rates again until core inflation returns to our 2 per cent target on a sustained basis.
Since cutting rates to near zero in 2008, the Fed has consistently overestimated the speed of inflation’s return to that target and repeatedly signalled that rates would go up quickly. For example, the median forecast in December 2014 showed rates rising to 3.625 per cent by 2017, far higher than markets expected or in fact happened.
Although the Fed didn’t realise it at the time, by sending a message suggesting rate increases, this forward guidance was contractionary rather than stimulative. Announcing a commitment not to raise rates until inflation returns to target would prevent us from making that mistake again. What is more, if we take the risk of premature rate increases off the table, lower long-term rates should provide support to the economy.
If a recession is coming, we may end up with rates back at zero, but we should take action now to try to avoid the recession and the ditch.
See Neel Kashkari’s op-ed in the Financial Times.