Fed Should Ease After U.K.'s Vote
Britain's vote to exit the European Union and the reaction in global markets offer important lessons for the Federal Reserve. It should be easing policy in the near term.
The outcome of the Brexit vote came as a big surprise to global markets. Over the past two trading days, we have seen large increases in sovereign debt prices and large declines in the value of the British pound.
The vote also opens up the possibility of many more surprises. Over the next few months and years, we will learn a lot more about how Brexit will be negotiated and how those negotiations will affect the U.K. and European economies.
We will also find out how Britain's departure will affect the financial and economic stability of the countries remaining in the European Union. There is a significant downside risk to global demand for goods and services -- and to U.S. prices and employment -- associated with the answers to all of these questions.
But these matters are hardly the only significant ones facing the global economy. We all know that China can’t keep growing at 7 percent a year forever. But how quickly, and to what level, will its growth rate fall? Businesses in emerging markets have large amounts of debt. How will that debt affect those countries’ growth prospects? As with Brexit, the possible answers to these questions represent significant downside risks to global economies and the U.S.
There are, of course, upside risks that could lead to unduly high U.S. inflation. But the Fed can always deal with those outcomes by setting interest rates high enough to choke off inflationary pressures. The problem is that, even with the federal funds rate below one half of one percent, inflation and employment are already quite low. How will the Fed succeed in keeping inflation and employment close to its mandated objectives if any of these adverse shocks occur?
This basic asymmetry means that the Fed should be doing two things. First, it needs to be clear that it does have a large toolkit to confront downside risks. Based on the lessons from several European monetary authorities, this toolkit should include negative interest rates. The Fed should begin the educational process about this tool -- with Congress and the public -- now.
Second, healthy patients withstand hard-to-treat illnesses better than unhealthy patients. Given the prospect of shocks that are hard to offset, the Fed should be easing monetary policy to make the U.S. economy as healthy as possible. This would be a big change: For the past three years, the Fed has been deliberately dampening the vitality of the U.S. economy by tightening monetary policy.
I’m sure some readers are asking: It’s been nearly eight years since the Fed cut rates to zero, will it ever be able to raise rates? Unlike some others, I remain optimistic that, over the longer run, the fed funds rate will be close to 3 percent. But the kind of ongoing global uncertainties described above are a significant drag on the demand for U.S. goods and services -- and that drag serves to push down on the fed funds rate consistent with the Fed's dual mandate.
The long-run fed funds rate will only be much higher than its current level if the Fed is clearly seen to be willing and able to reduce the effect of any downside risks to prices and employment. It can best display that commitment by cutting interest rates in July, not leaving them unchanged or raising them.
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