Will the Fed be Able to Respond to the Next Recession

On the blogosphere, there is an interesting debate about whether, when the next recession arrives, interests rates will be high enough that the normal approach of cutting the target federal funds rate will be sufficient.

In chronological order David Reifschneider, Jared Bernstein, Paul Krugman and Dean Baker contribute their thoughts (and in the case of Reifschneider extensive calculations and new research).

In an influential (pdf warning) paper , Reifschneider cautiously comes close to concluding that, given current Fed policy and in particular the 2% inflation target, the safe short term interest rate will probably rise enough before the next business cycle peak that cutting it will be enough.

Jared Bernstein thinks very highly of the paper, but is not convinced by the conclusion.

“I am not much comforted. There are a lot of “ifs” in Reifschneider’s story (all of which he is totally straight up about).”

if [skip] if [skip] if the QE and guidance have the positive growth and jobs impacts the model says they do; if people’s expectations are truly moved by the forward guidance, which implies future Fed officials will maintain the program. Then sure, sounds good.

Importantly, Bernstein is not convinced that Fed forward guidance actually guides expectations.

I think I will just quote (his explanation is better than my effort)

But I’m skeptical. The figure below, from Bloomberg News, shows a real problem for “if” No. 1. It draws a line through the “dot plots”: the Fed’s own predictions about where rates will go. The 3 percent at the end of the figure is the perch Reifschneider assumes they’ll get to before the next downturn.


The other lines at the bottom of the figure are the problem. They show market expectations of the funds rate and the fact that they’re so low creates a double problem for the Fed. First, if the markets are right, the limited firepower problem will be acute. Second, credibility. Remember, forward guidance works through market participants altering their expectations. At this point, the markets don’t believe the Fed’s projections.

It is very very clear that investors expectations about future Fed policy are not determined by FOMC forecasts of future Fed policy. At the moment, market participants expect a much lower Federal Funds Rate, but the point is that the listen, they hear, but they don’t necessarily believe. Regular readers know I totally agree and think this is a very important point. Also, I very much agree with “Re “if” No. 3, and again, Reifschneider is forthright on this point (I found his paper to be a model of clarity and caution), there are reasons to worry about whether monetary policy really has the growth and jobs punch the model says it does.” I have been worrying about overestimates of the effects of QE for 6 years now.

Paul Krugman agrees. As usual, he stresses asymmetric risks. He argues that “as Jared says, if the argument is wrong in any of several plausible ways — say, if the natural rate of interest is now much lower than it was in the past — this could be very wrong.”

Interestingly and unusually, Dean Baker disagrees with Krugman. Now I hate the fact that I almost never disagree with Krugman, so this raised my hopes.

Baker is brilliant as usual. He argues

… I can’t say I share their concern.

First, we have to remember that recessions aren’t something that just happens (like global warming :)). Recessions are caused by one of two things: either the Fed brings them on as a result of raising interest rates to combat inflation or a bubble bursts throwing the economy into a recession.

Taking these in turn, if the Fed were raising interest rates in response to actual inflation (and not the creative imagination of FOMC members) then we would presumably be looking at a higher interest rate structure throughout the economy. In that case, the Fed should then have more or less as much room to maneuver as it has in prior recessions.

The bubble story could be bad news, …

Baker then argues that it is possible to detect bubbles and prevent them from expanding to dangerous levels (sizes ? volumes ?) before they burst. This gives him another chance to remind readers of the many times he warned of the housing bubble before it burst, and of the fact that he warned that it would cause a severe recession when it burst.

I have some problems with this. First, I don’t think that even the very smart Dean Baker should be so confident.

Second it isn’t clear to me what should be done about a bubble which inflates without causing the economy to over heat. The housing bubble could have been restrained by high interest rates, but at the cost of high unemployment since it didn’t lead to extraordinarily low unemployment. And housing is the one sector which the Fed can most easily restrain. I’m not so sure that higher interest rates would have restrained dot com mania (fortunately the bursting of that bubble did little damage). I’d feel a whole lot better if I could think of a case in human history of a bubble which was restrained by the monetary authority (that is of a soft landing).

Third, and this is relatively important, it isn’t as if the USA has the exorbitant privilege of being the only economy which can initiate a world wide recession. There sure seems to be a huge construction bubble in China (a huge increase in leverage and also less concrete was poured in the USA in history than in the PRC in the last 3 hours or whatever). The USA doesn’t rely all the much on exports, but the correlation of GDP growth in different countries is much higher than that which can be explained through trade flows (writes Krugman who should know).

I am old enough to remember the Oil shocks. The recessions which followed the oil shocks look a bit like ordinary inflation fighting recessions, but, at the time, the unique features were very much stressed. I think it is in large part a coincidence that they followed periods of slack monetary policy, tight labor markets and accelerating inflation. I think such a shock hitting an economy with low inflation and anchored inflation expectations could cause a recession with low interest rates at the peak.

Finally what about total collapse of Europe ? It often seems possible over here.