Happy Days Not Quite Here Again for Fed Still Wary of Zero Rates

  • Sentiment brightening but U.S.economy still far from normal
  • Trend growth still weighed down by productivity, demographics

Things are looking up. U.S. growth forecasts are on the rise, employers continue to add jobs without stressing inflation, and consumer and business sentiment have bounced impressively.

But don’t get too excited. Recoveries don’t last forever, and whenever this one comes to an end, it may be difficult to argue the economy will have, in fact, recovered.

“We’ve seen a sea change in sentiment, but I think people are getting a little carried away,” said Joseph Davis, chief economist at Vanguard Group Inc., the world’s biggest mutual fund company. “The forces that matter all point to a world of lower growth.”

The difference between a cyclical upturn that bumps U.S. growth modestly above the post-crisis average of 2.1 percent and a structural shift that restores pre-crisis levels of expansion is important, and not only for the obvious reason that faster is better. It’ll be a crucial determinant of the capacity of monetary policy to handle the next downturn. And until the Federal Reserve is more confident it has that ability, policy makers will have an extra reason to stick to gradual rate increases.

If borrowing costs rise in line with the central bank’s December projections for three quarter-point hikes a year over the next three years, that will still leave the benchmark federal funds rate shy of 3 percent at the end of 2019. Futures contracts imply that investors don’t even expect it to reach 2 percent.

That’s not nearly room enough for comfort. In response to the eight recessions from 1957 through 2001, policy makers lowered rates by an average 5.5 percentage points, according to Fed data. The last time a U.S. recession prompted rate cuts totaling less than 3 percentage points was 1960-61.

Zero Rate

In other words, in the absence of a surprisingly strong surge in growth, a garden variety recession any time in the next three years is likely to send the policy rate straight back to zero, a perilous scenario never seen in the U.S. before 2008 and one that took seven years to escape. Depending on the severity and timing of a recession, it might also push the Fed, worried by the specter of deflation, to reach once again for asset purchases, where trouble surely awaits.

For one, asset purchases aren’t considered as effective as rate cuts. “When inflation is too low and our policy rate is stuck at the zero lower bound, we struggle to provide adequate accommodation with unconventional policies,” Charles Evans, president of the Chicago Fed, said in a speech Friday.

Then there’s politics. The Fed provoked howls of protest from Republican lawmakers with three rounds of so-called quantitative easing, or QE, in and after the Great Recession. In their view, Fed over-stepped its authority with asset purchases and encouraged Barack Obama’s Treasury department to issue more debt.

Loud Outcry

The outcry could grow louder with yet another round. The bank’s balance sheet remains close to $4.5 trillion, up from about $900 billion before the crisis exploded in 2008, and officials are only now beginning to discuss how and when they might gently reduce its size.

“I would not exclude by 2018-19 coming back to zero, and for the Fed to start QE again, but the bar is now much higher than in the past because of the politics,” said Thomas Costerg, senior U.S. economist at Standard Chartered Bank.

Such gloominess may seem out of step generally with the economy’s steady progress and specifically with the recent slew of positive indicators on sentiment. After declining through most of last year, the median forecast for economic growth in 2017 has risen since November to 2.3 percent from 2.1 percent, according to a Bloomberg survey of economists. Meantime, the University of Michigan’s gauge of consumer sentiment rose last month to a 13-year high, and the National Federation of Independent Business’s index of small-business optimism soared in December by the most since 1980. 

Corporate Confidence

More confidence in the corporate sector is especially encouraging given that business investment has been persistently disappointing, but sentiment does not always translate into spending. Moreover, the problems economists and policy makers worry most about lie in long-term trends that are either notoriously difficult to predict -- productivity -- or unlikely to improve -- demographics.

Fed Chair Janet Yellen has called productivity the “key determinant” of living standards over the long run and described its growth rate since the crisis as “exceptionally slow.” Since 2010, it’s averaged just 0.7 percent annually, compared to 2.4 percent in the 20 years through 2009. That accounts for most of the gap between average growth in the U.S. of 3.5 percent from 1948 through 2007, and 1.3 percent since.

Meanwhile, America is getting older, a process that’s hard to imagine going in reverse, particularly if President Donald Trump places greater restrictions on immigration. Demographic mathematics mean the size of the labor force relative to the overall population is dropping and will continue to drop.

In addition, and for less understood reasons, the proportion of working age Americans who participate in the work force has declined in recent years, further lowering potential growth. Continued technological advances, which on one hand help boost productivity, will likely make this worse.

As long as potential growth remains low, “central bankers will face uncomfortably large odds of having to cut conventional policy rates to zero,” Evans said.

This is not just the pessimists’ view.

Mickey Levy, chief economist for the Americas and Asia at Berenberg Capital Markets LLC in New York, has an above-consensus forecast of 3 percent growth in 2018. He’s hopeful Trump can boost the economy long-term by easing regulation and cutting corporate taxes. Yet Levy concedes his outlook doesn’t necessarily boost growth far enough to bring back the old normal.

“I can’t rule out dealing with the zero-lower bound, even in the optimistic scenario,” he said. “It looms out there until you get a much higher federal funds rate.”