US Fed’s Ability to Respond to Recession is NIL
$DIA, $SPY, $QQQ, $VXX
US Fed officials fear that they lack the policy tools to combat future cyclical shocks to the US economy, an issue expected to be debated at the annual Jackson Hole Wyoming Summit later this week.
The historically low Federal funds rate, Zero+, the central bank’s balloned balance sheet, and the US economy’s failure to fully recover from the 2008 financial crisis all reduce power of conventional monetary policy tools should a recession hit the US economy in the coming years.
A new Fed staff working paper published at the weekend could serve as a guide to how Fed officials view their own firepower under the current policy course.
Economist David Reifschneider, its author, 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 these current lows.
Mr. 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% in the coming years, which is consistent with FOMC participants’ long-run projections at the June 2016 meeting.
In a research note published Monday, the global head of G10 FX strategy at Citigroup Inc. (NYSE:C), points out the paper’s benign starting point for the US economy: full employment, inflation at 2%, 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 2 years, since the paper’s projected outlook for rates is not in line with market assumptions.
The paper uses the Fed’s standard US economic model and exposes it to a negative shock to push the unemployment rate up by 5%. It then tests out the Fed’s various tools, from the policy rate, QE (quantitative easing), 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,” Mr. Reifschneider writes.
In the event of a US economic shock, Mr. Reifschneider says that a huge, upfront commitment to launch a $4-T QE program combined with aggressive forward-guidance would send long-term US 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 is a big thing to launch forward guidance and stimulus on this scale from the get-go. The Fed’s current balance sheet is $4.5-T, compared with under $1-T pre-2008 crisis.
The Key issue is that the stimulation starts with the nominal Fed funds rate at either 2 or 3%, compared with 0.5% currently, and that the paper’s correct premise being, “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 US recession within the next 2 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 bpts Fed funds rate at the end of Y 2019, for example, compared with the FOMC’s median Fed funds rate projection of 2.4% at the end of Y 2018.
Based on Mr. Reifschneider’s model the US Fed would only be able to offset a 0.2% shock to the unemployment rate given both where rates are currently and Fed officials’ commitment not to take rates into negative territory.
In that simulation, QE and forward guidance take 10 year yields down 225 bpts to 300 bpts depending on the starting point for Fed funds and whether you do $2-T or $4-T for QE.
Hawks may 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 the paper is another argument to continue stimulating the US economy now so it is in a better shape to weather those futures shocks.
Whether this issue 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.
Mr. Reifschneider says the Fed’s ability to respond to a significant US downturn could be weaker than the model suggests given structural weaknesses in the economy, “implying accommodative fiscal policy” would be needed.
Wednesday, the US major stock market indexes finished at: DJIA -65.82 at 18481.48, NAS Comp -42.38 at 5217.69, S&P 500-11.46 at 2175.44
Volume: Trade was light with 736.2-M/shares exchanged on the NYSE
- Russell 2000 +8.9% YTD
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- NAS Comp +4.2% YTD
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