A New Paper Reveals the Fed's Policy Impotence If Another Recession Hits Soon

Fiscal policy and negative policy rates might be needed, says Citigroup Inc.

El-Erian: Federal Reserve Needs to Lead the Market

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.

Drawing upon simulations from the paper itself, the Citigroup strategist argues the large‐scale asset purchases and forward guidance about the future path of the Federal funds rate would "have almost no ability to offset a shock in current circumstances," citing the fact that policy rates are likely to be coming off a lower base than the paper projects. Markets are pricing in a 100 basis points Fed funds rate at the end of 2019, for example, compared with the FOMC's median Fed funds rate projection of 2.4 percent at the end of 2018.

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Based on Reifschneider's model, Englander says the Fed would only be able to offset a 0.2 percent shock to the unemployment rate given both where rates are currently and Fed officials' commitment not to take rates into negative territory.

"In the simulation, QE and forward guidance take 10 year yields down 225 basis points to 300 basis points depending on the starting point for Fed funds and whether you do $2 trillion or $4 trillion for QE," he says. "But that is not going to work very well if, by design, Fed funds and 10 year yields can’t go below zero. And if expected rates are already low then forward guidance does not have much room" to stimulate the economy. In effect, Fed officials would have to "keep a straight face while saying they we will keep rates at zero … forever."

Hawks might seize on this paper to argue that rates should be raised sooner in order to give the Fed a bigger margin to cut rates in the event of an economic downturn, but Englander says the paper is another argument to continue stimulating the U.S. economy now so it's in a better shape to weather those futures shocks.

"Whether it is presented formally at Jackson Hole, or is in the background, it is likely to be viewed as presenting the baseline ability of the current set of policy parameters to affect outcomes," writes  Englander.

Reifschneider himself says the Fed's ability to respond to a significant U.S. downturn could be weaker than the model suggests given structural weaknesses in the economy, "implying accommodative fiscal policy" would be needed.

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