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.