Does the US have enough firepower to fight the next recession?

Low starting interest rates means that the Federal Reserve (Fed) may need to expand its policy toolkit to fight an economic downturn. But if this proves insufficient, fiscal policy need to pick up the slack.

The go-to policy tool to fight an economic downturn has been monetary policy. In post-war recessions, the Fed has, on average, cut short-term interest rates by five percentage points to stimulate the economy (four percentage points in inflation-adjusted terms).

However, rates are 2.5% today and are only expected to rise to 2.75% this year. Their rate-cutting ability has been neutered. With the odds of a recession occurring in the next two years having risen to 40 percent, other responses are likely to be required, according to a Reuters poll in December 2018.

Low starting interest rates give the Fed less ammunition to fight the next downturn

Notes: Difference between the peak in effective fed funds rate 12 months before recession began and trough 12 months after it ended. *Next recession assumes that interest rates peak at 2.75%, which is the median FOMC forecast for the long-run federal funds rate as at 19 December 2018. Source: Datastream, FRED and Schroders.

Can interest rates go negative?

In pursuit of additional policy tools, the Fed could make short-term interest rates negative, as has happened in the eurozone, Japan, Switzerland, Sweden and Denmark. Negative interest rates would penalise consumers and businesses for hoarding savings in their bank accounts, as its value would decrease over time. The aim would be to incentivise them to borrow, spend and invest. It can also have a desirable effect on other channels such as asset prices, the exchange rate and government borrowing costs.

At some point though, holding physical cash and storing it yourself to avoid negative interest rates can become a viable alternative although, for large sums of money, storage and security costs are a barrier. To avoid the risk of a run on a bank, driven by consumers withdrawing cash, banks may keep deposit rates at zero. This is what happened in other countries that implemented negative policy rates¹.

However, in the long run, this harms bank profitability, as the rate they earn on their cash accounts held at the central bank is negative but the rate they pay out to consumers is held at zero². So while negative interest rates may help to stimulate demand, they cannot fully make up for the lost policy space without creating problems for banks.

Re-start quantitative easing (QE)?

To make up for the missing firepower, the Fed could resume its QE programme – buying long-term government and/or quasi-government securities – in order to lower long-term borrowing costs for consumers and businesses. Previous rounds of QE between 2009 and 2014 are estimated to have generated a cumulative macroeconomic effect equivalent to a two and a half percentage point cut in the federal funds rate³.

The issue is that a number of policymakers fret about the unintended costs of further QE, such as asset bubbles forming and rising economic inequality, which could limit the extent to which they undertake additional large-scale purchases of financial assets.

What about abandoning inflation targeting in favour of price-level targeting?

Some pundits have been calling for an alternative framework of forward guidance – statements to influence the market’s perception about the likely path of short rates – that would apply only under exceptional circumstances. For example, the Fed could adopt a temporary price-level target to keep the long run average inflation rate at two percent only when short-term rates are at or close to zero.

Rates would then be kept lower for longer to make up for the periods when inflation was below target. By influencing expectations about the future path of short rates, the Fed could overcome its lost policy space, as the market would lower long-term rates. However, similar to QE, policymakers would need to carefully assess the long-term benefits and risks of this approach.

Can fiscal policy ride to the rescue?

This leaves government spending or tax cuts as the potential saviour. The recent surge in populism has certainly increased the public appetite for such measures. But some observers say that a poorly-timed US tax-reform has reduced the potential to deliver a countercyclical fiscal stimulus package. For example, the US deficit for 2020 is projected to be more than double the average pre-recession level and US debt already exceeds 100% of GDP⁴.

Even so, the binding constraint on fiscal policy is arguably not the fiscal deficit or debt-to-GDP, but whether the interest rate paid on government debt exceeds the economy’s growth rate. A recently published academic paper by the former IMF chief economist, Olivier Blanchard, challenges the view that high public debt levels are a problem. His argument is that, as long as interest rates are expected to remain below growth rates, then debt can be issued to finance government spending without raising taxes⁵.

On average, the 10-year Treasury yield has been lower than the nominal growth rate of GDP (see chart below). So questions about fiscal sustainability really boil down to whether this trend is likely to continue. Assuming the Fed does return to QE (or use other unconventional policy tools) and investors are willing to finance the US deficit, then the US probably has more fiscal room to stimulate the economy during a recession than it appreciates. 

The interest rate on long-term government debt has frequently fallen below the growth rate of GDP

Notes: the long-term average maturity of US Treasury debt is 5 years, so the overall fiscal cost of debt is probably lower than displayed above. Source: Datastream, FRED, Robert Schiller and Schroders. Data to 30 December 2018.

The verdict

So does the US have enough firepower to fight the next recession? The Fed is not out of ammunition and can implement alternative monetary policies, but it is unclear whether they can fully compensate for lower starting interest rates. This suggests that fiscal policy action will most likely be needed to ease the burden of stabilising the economy during a downturn.

^{1. Eggerstsson, G. and Summers, L.H. “Negative interest rate policy and the bank lending channel”. VOX. 24 January 2019.↩}

^{2. Lopez, J.A. Rose, A and Spiegel, M. “Bank performance under negative interest rates.” VOX. 2 October 2018.↩}

^{3. Gagnon, J.E. (2016). “Quantitative Easing: An Underappreciated Success.” Peterson Institute for International Economics.↩}

^{4. Source: Datastream and Schroders.↩}

^{5. Blanchard, O. (2018). “Public Debt and Low Interest Rates.”↩}