Federal Reserve Board (FRB) officials are beset with fears
they lack the policy tools to combat future cyclical shocks to the
U.S. economy, an issue expected to be debated at the annual Jackson
Hole summit later this week.
The historically low Federal funds rate, the central bank's
still-large balance sheet, and the U.S. economy's failure to fully
recover from the last crisis all potentially dent the firepower of
conventional monetary policy tools should a recession hit the U.S.
economy in the coming years.
A new Fed staff working paper published over the weekend could
serve as a guide to how Fed officials view their own firepower under
the current policy course. The author, economist David
Reifschneider, strikes an upbeat note about the Fed's ability to
juice the economy, but the paper also highlights the uphill battle
it would face using conventional policy tools if as the markets
expect, rates remain at stubborn lows.
Reifschneider shows how the Fed would have the scope to respond
to an economic shock if the federal funds rate hits a still-low 3
percent in the coming years, which is consistent with Federal Open
Market Committee participants' long-run projections at the June 2016
meeting.
However, in a research note published on Monday, Steven
Englander, global head of G10 FX strategy at Citigroup Inc., points
out the paper's benign starting point for the U.S. economy full
employment, inflation at 2 percent, and interest rates at normal
longer-run levels and its methodology, actually reveal the central
bank's policy impotence if a recession hits in the next two years,
since the paper's projected outlook for rates is not in line with
market assumptions.
The paper uses the Fed's standard U.S. economic model and exposes
it to a negative shock to push the unemployment rate up by 5
percentage points. It then tests out the Fed's various tools from
the policy rate, quantitative easing (QE), to forward guidance to
see if they succeed in getting the economy back on track.
"Simulations of the FRB/US model of a severe recession suggest
that large-scale asset purchases and forward guidance about the
future path of the federal funds rate should be able to provide
enough additional accommodation to fully compensate for a more
limited to cut short-term interest rates in most, but probably not
all, circumstances," Reifschneider writes.
In the event of a U.S. economic shock, Reifschneider says that a
huge, upfront commitment to launch a $4 trillion QE program combined
with aggressive forward-guidance would send long-term Treasury
yields lower, offsetting the zero-lower-bound constraint for
short-term rates. And this would, in turn, succeed in juicing the
economy.
But he acknowledges that it's a big ask to launch forward
guidance and stimulus on this scale from the get-go. The Fed's
current balance sheet is $4.5 trillion, compared with under $1
trillion pre-crisis.
The main issue is that the stimulation starts with the
nominal Fed funds rate at either 2 percent or 3 percent,
compared with 0.5 percent currently, and Englander says that the
paper's correct premise that the effectiveness of policy tools
to stimulate activity increases the higher the benchmark policy
rate is before a shock kicks in actually reveals the Fed's
inability to deal with a U.S. recession within the next two
years.
Drawing upon simulations from the paper itself, the Citigroup
strategist argues the large‐scale asset purchases and forward
guidance about the future path of the Federal funds rate would
"have almost no ability to offset a shock in current
circumstances," citing the fact that policy rates are likely to
be coming off a lower base than the paper projects.
Markets are pricing in a 100 basis points Fed funds rate at
the end of 2019, for example, compared with the FOMC's median
Fed funds rate projection of 2.4 percent at the end of 2018.
Based on Reifschneider's model, Englander says the Fed would
only be able to offset a 0.2 percent shock to the unemployment
rate given both where rates are currently and Fed officials'
commitment not to take rates into negative territory.
"In the simulation, QE and forward guidance take 10 year
yields down 225 basis points to 300 basis points depending on
the starting point for Fed funds and whether you do $2 trillion
or $4 trillion for QE," he says.
"But that is not going to work very well if, by design, Fed
funds and 10 year yields cant go below zero. And if expected
rates are already low then forward guidance does not have much
room" to stimulate the economy. In effect, Fed officials would
have to "keep a straight face while saying they we will keep
rates at zero
forever."
Hawks might seize on this paper to argue that rates should be
raised sooner in order to give the Fed a bigger margin to cut
rates in the event of an economic downturn, but Englander says
the paper is another argument to continue stimulating the U.S.
economy now so it's in a better shape to weather those futures
shocks.
"Whether it is presented formally at Jackson Hole, or is in
the background, it is likely to be viewed as presenting the
baseline ability of the current set of policy parameters to
affect outcomes," writes Englander.
Reifschneider himself says the Fed's ability to respond to a
significant U.S. downturn could be weaker than the model
suggests given structural weaknesses in the economy, "implying
accommodative fiscal policy" would be needed.
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