Fed Clueless on How To Handle Next Downturn

As the Federal Reserve printed trillions of dollars in the early 2010s, it forecast that short term interest rates would rise above 3% by 2016.  As that year got closer, the central bankers pushed the forecast to 2018, then 2019, and then lowered their forecast.

None of their models showed the U.S. growing at a modest 2% for a decade, with unemployment falling to 50-year lows and weak inflation.  Instead of raising rates to choke off inflation, the Fed lowered rates three times over the past year and now the Fed Funds rate sits at a mere 1.5%.

When the next recession comes, the Fed is out of ammunition.  That has them worried and looking for new approaches.

A conference of bankers on the topic produced a flourish of ideas, including a call from former Fed Chair Ben Bernanke to make once-unconventional monetary policy tools like bond-buying a permanent part of the central bank’s arsenal – in effect making the tactics he used to counter the 2007-09 financial crisis a staple part of Fed recession-fighting.

With a Federal Funds target rate unlikely to rise much beyond 2 to 3 percent, and currently set lower than that, the Fed would not have enough “firepower” otherwise to battle the next downturn, he said.

Former Fed Chair Janet Yellen called for better tools for financial regulation, such as putting stricter limits on mortgage credit to prevent low interest rates from encouraging risky borrowing.

Nellie Liang, a senior fellow at the Brookings Institution and former head of the Fed’s financial stability division, said:

“We have low inflation. We’ve got lots of employment. If we keep rates low because inflation is not high … what kind of financial vulnerabilities might you build and how much does that increase the downside tail risk four quarters out, eight quarters out?  These vulnerabilities build over time … You get better stuff now at the cost of worse later.”

As expected, no one at a conference full of bankers suggested that the bankers set a mechanical system for determining short-term rates, such as the Taylor Rule, and then just get out of the way.  Instead, the proposed many ways for bankers to get more involved in tinkering with the financial system instead of letting the markets determine rates.



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