Almost 10 years after the Great Recession ended, the growing threat of a new economic slowdown raises a troubling question: When the next recession strikes, what can the world’s central banks do? With interest rates low and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? This column is one of six looking at that question.
To its credit, the Federal Reserve is holding a conference this summer on whether it should make changes to how it operates. The first question on its agenda should be how to handle the next recession.
That’s not because it’s the organization’s only mission. A 1977 law directs it to seek “maximum employment, stable prices and moderate long-term interest rates.” But recent experience suggests that it’s the first part of that mission that is most in question over the course of the business cycle.
From roughly 1966 through 1981, many observers had justifiable doubts about whether the Fed could vanquish inflation. But since then, the Fed has been winning that battle in a rout. It has arguably been too successful: Over the last decade, it has consistently missed its inflation target by falling short of it rather than exceeding it.
The Fed did not perform as well during the financial crisis, the Great Recession and their aftermath. That proposition is controversial, since it is often claimed that the central bank’s stimulative policies, combined with the bipartisan Troubled Assets Relief Program and President Barack Obama’s fiscal stimulus, rescued us from a reprise of the Great Depression.
Fed policy was too tight during 2008. It held interest rates flat from April to October even as the economy was weakening, and spent much of that time signaling that higher interest rates were on the way. Officials were warning about the dangers of inflation while the market indicators showed that the expected rate was falling.
Even when Lehman Brothers collapsed, the Fed cited inflationary risk and declined to reduce interest rates. Weeks later, it took the contractionary step of starting to pay interest on banks’ excess reserves. Only then did it reduce the federal-funds rate. Even Ben Bernanke, then the Fed’s chair, has said that it waited too long to cut interest rates.
After the crisis hit, the Fed kept the federal-funds rate low and engaged in several rounds of quantitative easing. Its policies were therefore commonly described as accommodative. But these policies were much less stimulative than apparent at first glance.
The neutral interest rate in a depressed economy is low, so actual interest rates have to be even lower to give the economy a lift. The Fed undercut the effect of its expansions of its balance sheet on market expectations of future income by signaling that those expansions would be temporary. And it continued to pay the banks interest on excess reserves.
In part because of the consensus that monetary policy was already quite easy, the Fed refrained from moving to an easier policy even as unemployment remained high and inflation persistently registered below the target of a 2 percent annual rate.