One Problem with the Fed Letting Its Interest Rate Crest at 2.5%
March 26, 2019
Share prices are rallying today in part on hopes that the Federal Reserve has reacted quickly to a deterioration in the outlook for global and U.S. growth. By doing so, maybe the inversion of the U.S. yield curve that recently occurred will be the exception that doesn’t herald a U.S. recession within 18 months. I agree that the Federal Open Market Committee acted appropriately, but avoiding excessive future inflation amid a tight and tightening labor market was not the sole justification for the prior strategy of interest rate normalization.
Monetary officials were also trying to be prepared when the next recession comes, as it will inevitably. When that happens, there will be scant scope for fiscal stimulus. Thanks to the deficit-ballooning tax cut of the Trump administration, a fiscal option will not be available, and the Fed is likely to be the first and only response team.
Previous Fed rate-cutting cycles began at a considerably higher rate level than the 2.5% upper boundary of the 2.25-2.50% current federal funds target range. In May 1989, the funds rate was 9.75% versus CPI inflation of 5.4% and unemployment of 5.2%. In July 1995, the funds rate was at 6.0%, set against 2.8% CPI inflation and 5.7% unemployment. The initial cut of the fed funds rate in September 1998 was from 5.5% when CPI inflation stood at 1.5% (same as now) and unemployment was 4.6% (0.8 percentage points higher than now). By January 2001 when the next Fed rate-reduction cycle commenced, the funds target had climbed all the way to 6.5% versus a 4.2% jobless rate and 5.7% inflation. And the Fed’s first response to the sub-prime mortgage financial market crisis in September 2007 was made with the funds rate at 5.25%, unemployment of 4.7% and CPI inflation of 2.8%.
During the Great Recession, we learned that monetary policy can be implemented quite effectively in other ways than by cutting the central bank interest rate. However, quantitative stimulus was then begun after the Fed had cut its federal funds target by five percentage points in just over one year’s time. The effectiveness of asset purchases by the central bank was likely greased by the initial conventional step of cutting short-term interest rates very sharply. Quantitative stimulus in the United States may not prove quite so powerful the next time around if preceded by interest rate cuts from a peak of just 2.5%, or perhaps 2.75%. In Japan, quantitative monetary easing has been practiced for far longer than in the United States but with much less bang for the buck (or yen in their case).
The Bank of Japan hasn’t managed to get the overnight Japanese interest rate above 0.50% since September 1995 — more than a generation ago — for the simple reason that the Japanese economy repeatedly proved unable to tolerate a rate hike beyond that level. Japan got into its mess in large part because of unsound monetary policy. The central bank stance was way too accommodative in the roaring 1980s and then far too stingy in the 1990s. One concern regarding future fed policy is that there has been extensive turnover lately of policymakers at the top. Hopefully, the new leadership will have enough institutional memory to guide it through the next recession while avoiding the kind of policy mistakes made in Japan and in earlier eras too at the Fed. That would have been an easier task if the federal funds rate were at a higher level than now when the next recession begins.
Copyright 2019, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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