When a recession threatens, the Federal Reserve has a trusty method for either preventing it or minimizing its damage: Cut interest rates — by a lot, if necessary.
But what happens when interest rates stay near record lows even in good times?
With the economic expansion on track to become the longest on record, one of the most important beneath-the-radar policy conversations in Washington will take place in the coming months. Fed officials are undertaking the most extensive rethinking of how they set monetary policy since they set a formal target for inflation seven years ago. The results will help determine how long it can keep the good times going and how effectively it will be able to fight the next downturn.
In the near term, any changes are likely to tilt policy in the direction of having lower interest rates for longer periods, with the aim of getting inflation to more consistently average 2 percent (it has been consistently below that level for years). The review comes as President Trump has pressured the Fed toward lower rates, including through public attacks and planned appointments to the central bank’s board of governors.
Led by the Fed vice chairman, Richard Clarida, the assessment is more likely to produce “evolution rather than revolution,” the chairman, Jerome Powell, said in a recent speech. In particular, Fed officials have ruled out raising the 2 percent inflation target, a step that might give it more flexibility to respond to future downturns but would mean less stable prices.
The review comes as the shortcomings of the Fed’s current strategy are growing more clear. Even after a decade of economic growth and amid an unemployment rate as low as it has been in decades, the Fed’s main policy interest rate remains below 2.5 percent. And inflation has been persistently below the 2 percent rate the Fed aims for.
The same is true in other major economies, suggesting that powerful global forces are holding down inflation and interest rates worldwide — and there is little reason to think that will change soon.
As a result, the Fed simply has fewer arrows in its quiver to protect the economy from the normal ups and downs. It also has a widening credibility gap over an inability to reach its inflation goal. Fed officials do not envision raising rates further anytime soon, and there are signals in financial markets suggesting that if they did raise rates much above current levels, the economy could tumble into recession.
If the economy sours, cutting the federal funds rate from its current levels — around 2.4 percent — to near zero wouldn’t offer nearly the stimulative boost that was delivered the last two times recessionary forces emerged. Back then, the starting point was far higher: 5.25 percent (in 2007) and 6.5 percent (in 2000).
The traditional thinking has been that interest rates cannot go below zero. If they did, that would mean savers would pay banks to hold their money rather than earning interest on it. In recent years some central banks have experimented with slightly negative rates, with uneven results, and Fed officials have been reluctant to follow them.
But the lower that rates are when the economy is healthy, the more often this “zero lower bound” or “effective lower bound” will pinch. Fed economists have run simulations suggesting that the central bank could find itself at that point 40 percent of the time in the future, signaling an economy that frequently needs more stimulus than the Fed is able to deliver through conventional means.
The problems of lower inflation and lower interest rates are intertwined. Since the Fed formally said it would aim for 2 percent yearly inflation, actual inflation has undershot the target each year.
“The proximity to the zero lower bound calls for more creative thinking about ways we can uphold the credibility of our inflation target,” Mr. Powell said in a March 20 news conference. “We’re open-minded about ways we can do that.”
These issues have been building for years, as the Fed has repeatedly lowered its estimate of the “neutral rate of interest,” or r* in economics-speak. This refers to the level of interest rates that neither slows nor stimulates the economy. A mix of forces, including demographic decline, low productivity growth and a global supply glut, are driving the declining r* estimate.
At a lunch on Mr. Clarida’s first day in office last September, Mr. Powell asked him to re-evaluate the Fed’s policy approach in light of those shifts. The effort started with public gatherings at reserve banks around the country; beginning in the summer, it will continue with closed-door meetings of the Fed’s policy committee.
In public, the officials play down expectations for any major rethinking of the Fed’s mandate, but it is clear to close watchers of the central bank that some significant change is likely to emerge.
“The way they’ve set this review up makes it very hard to end up reaffirming the old status quo,” said Krishna Guha, who leads central bank strategy at Evercore ISI. “They’ve explained why the old regime no longer works as well as in the past, and having explained that problem you can’t then conclude that what they’re doing is fine.”
One priority, according to a recent speech previewing the effort by Mr. Clarida and interviews with Fed officials, will be how the Fed should react when it misses its inflation target, as has happened year after year.
Presently, the Fed’s approach is known internally as the “bygones” approach — let what happened in the past be in the past, and set policy based only on what you expect for the future. Using that logic, the central bank has kept setting interest rates aimed at attaining 2 percent inflation.
In practice, that has meant the Fed has been the equivalent of a driver who aims to go 60 miles an hour but starts tapping the brakes every time the car gets over 55.
If, instead, the Fed tried to target a steadily rising price level, or achieve average inflation over many years of 2 percent, it might avoid the problem. That would be the equivalent of a driver with an average speed of 55 being comfortable driving at 65 miles per hour until the average rises to the goal of 60.
In the current monetary policy environment, it would mean keeping rates lower for longer, allowing the economy to overheat until inflation was tracking comfortably above 2 percent for a time.
There are problems with that approach. President Trump’s drumbeating for lower rates notwithstanding, there would most likely be political backlash during the time inflation was overshooting the goal — it would be as if our driver got a speeding ticket while going 65. Already in congressional testimony this year, Mr. Powell has heard from senators who implored him not to allow inflation to rise.
Moreover, the Fed might feel a need to raise rates not because of inflation risk, but because of potential financial bubbles. And it would still need to grapple with its credibility problem.
“I know people have talked about price level target or a nominal G.D.P. target,” said Neel Kashkari, president of the Minneapolis Fed. He said he finds those approaches intellectually appealing, but noted that the Fed’s rate increases have tended to be driven in part by a perceived risk of financial bubbles or sudden outbursts of inflation. “I don’t see why those risks go away” if you adopt one of the new approaches, he said.
Similarly, he added, “I’m interested in how we can make any commitment credible,” given the Fed’s consistent failure to reach its inflation goal in the last decade.
In other words, after a decade of undershooting, it may take more than just words to show that the Fed is serious about achieving its goals.