No Longer Fresh at Project Syndicate: The Fed Should Buy Recession Insurance: The next global downturn may well not be yet at hand: odds that the North Atlantic as a whole will be in recession in a year are now down to about one-fourth. German growth may well be positive this quarter. China might be rebounding this quarter. The U.S. is definitely slowing to 1% growth or so this quarter, but it is not yet clear that this slowdown will be more than a blip.
But if the next downturn is at hand, North Atlantic central banks do not have the policy room they would need to effectively fight it. Short-term safe interest rates in the U.S. are at 2.4%/year. If a recession does come, the Federal Reserve will wish that it could drop U.S. rates by the standard 5%-points. It cannot. Euro and yen rates are still at the zero lower bound, thus no effective help in recession-fighting can be expected from the ECB or the Bank of Japan.
Thus, looking forward, the big risk facing the Federal Reserve is not the upside risk that inflation will begin spiraling upward and the Federal Reserve will be unable to raise interest rates in a timely fashion to stabilize the economy. The big risk is the downside risk that the North Atlantic will be in recession in a year, that fiscal policy will not be mobilized to fight that recession, and the Federal Reserve will once again find itself at the zero lower bound, wishing that it could lower interest rates, and nearly helpless to even try to control the economy.
When you face an asymmetric risk, the natural response is—or ought to be—to try to buy insurance to cover that risk. What does that mean for the Federal Reserve today? What are its options?
The Federal Reserve's first option is the one that it is taking—not buying insurance at all. As Federal Reserve Chair Jay Powell declared on CBS on March 10: "Inflation is muted and our policy rate we think is in an appropriate place.... Patient means that we don’t feel any hurry to change our interest rate policy.... What’s happened in the last 90 or so days is that we’ve seen increasing evidence of the global economy slowing down.... We’re going to wait and see how those conditions evolve before we make any changes to our interest-rate policy.... The outlook for the U.S. economy is favorable. The principal risks to our economy now seem to be coming from slower growth in China and Europe and also risk events such as Brexit...”
The Federal Reserve's second option is to try to compensate for its possible inability to engage in more expansionary policy in a year if it turns out to be needed by engaging in more expansionary policy no. If growth recovers and strengthens—as more likely than not it will—there is no harm done. As long as inflation expectations are well-anchored—and they are—a looser monetary policy than the after-the-fact ideal one year can be fully and cheaply offset by a tighter monetary policy in the following year. But if growth does not recover and strengthen, and if the North Atlantic does fall into recession, the Federal Reserve in a year will greatly regret as it frantically cuts interest rates at the end of this year that it did not get ahead of the curve and preemptively cut them today.
The Federal Reserve's third option is to purchase recession insurance not by cutting interest rates today but by clearly and aggressively explaining how it would effectively fight a recession, should one come over the course of the next year. In order to do that, it would need to explain how things would be different if the economy were at the lower bound from 2020 on than they were when the economy was at the lower bound in the period starting in 2010. Back then Ben Bernanke's monetary policy—and his pleas to Republican legislators and austerians to put the interest of the country above scoring partisan points and aggressively pursue fiscal policy—were completely ineffective in generating growth faster than the previous trend. As a result, recover was anemic and unsatisfactory.
A credible plan to make things work differently should the Federal Reserve wind up back at the zero lower bound in 2020, 2021, or thereafter might well boost business confidence and make Federal Reserve policies more effective. It would at least reassure those who might be starting to pull back out fo a few that aggregate demand will be weak in 2020.
But this third would require an aggressive intellectual and communications effort that we do not see.
Instead, the Federal Reserve is pursuing the first option: it is not being insurance, And that is unwise.