Friday, August 26, 2016

Shocking the Economy the Federal Reserve Way

Largely because it was released over a mid-summer weekend and because it's one of those potentially sleep-inducing (at least outside of the academic economic world) working papers from the Federal Reserve, a paper entitled "Gauging the Ability of the FOMC to Respond to Future Recessions" has garnered relatively little attention.  The author of the paper, David Reifschneider, looks at how the Federal Reserve responded to the Great Recession and past economic contractions and how it will respond to the next recession, a recession that, statistically speaking, will arrive sooner rather than later.

As we all know, the Federal Reserve has traditionally used its interest rate policies as ammunition to ward off the horrifying spectres of inflation and economic contractions as shown on this table which provides us with the cumulative reductions in the federal funds rate over the past nine recessions:


Over the nine recessions, the average cumulative reduction in the federal funds rate ranged from 283 basis points (2.83 percent) to 1038 basis points (10.38 percent) with an average of With the federal funds rate currently sitting at around 0.4 percent, obviously, unless there are significant moves upwards over the coming months, the Fed basically has boxed itself into an interest rate policy corner. even if the current forecasts of a return to a three percent  federal funds rate prove to be true as shown on this table:


Fortunately for the central banker braintrust, they have other monetary weapons in their arsenal, weapons that have led to a massively bloated balance sheet since the end of the Great Recession as shown here:


....and here:


Lest we forget, the Federal Reserve also touts the success of its forward guidance program, you know, the program where they telegraph their future moves to avoid any surprises down the road.  This, from my uneducated perspective, has a fairly limited impact on the economy given that the Fed is still quite secretive about its exact plans and the precise timing of those plans.  In any case, given that the Fed has painted itself into an interest rate corner, it has no choice but to rely on its armoury of experimental monetary policies like quantitative easing.  To that end, the author assesses the adequacy of the FOMC's monetary policy toolkit if it were needed to combat a future "sharp" recession using the following economic data:

- PCE inflation is 2 percent, federal funds rate is 3 percent and stable

- recession occurs - unemployment rises 5 percentage points above its baseline to almost 10 percent after two years.  This is followed by a slow recovery in real economic activity with the unemployment rate taking three and a half years to return to normal and inflation falls to a low of 1.5 percent.

In the model, policymakers use two non-traditional monetary policy tools:

1.) they announce their intention to purchase either $2 trillion or $4 million in longer-term Treasuries and

2.) they make the unprecedented announcement that they will lower the federal funds rate to its effective lower bound (i.e. zero percent) more quickly and keep it there as long as the unemployment rate is above 5 percent, a "lower-for-onger" policy.

Now, let's look at three main scenarios, comparing the constrained policy rule (i.e. an effective lower bound is in place - blue dashed line), an unconstrained policy rule (i.e. there is no effective lower bound in place - red dashed line) and a constrained policy tool with forward guidance and asset purchases (solid black line).  This set of graphs shows the impact of the $2 trillion asset purchase and lower-for-longer guidance on the federal funds rate, the ten-year Treasury yield, unemployment rate and inflation rate:


This set of graphs shows the impact of the $4 trillion asset purchase and lower-for-longer guidance on the federal funds rate, the ten-year Treasury yield, unemployment rate and inflation rate:


It is interesting to see how low the federal funds rate will go into negative territory in both cases where there is no effective lower bound (red dashed line).  It is also interesting to see that, in the $4 trillion QE scenario, the ten-year Treasury yield in the constrained policy with asset purchases drops to just over 1 percent and in the unconstrained policy, drops to less than 0.5 percent or less than one-third of what the yield is at the present time.


While a lot of this analysis is academic, it is, nonetheless interesting because it provides us with a glimpse of the Federal Reserve's mindset.   While the Fed claims that the interest rate highs of the past were "economic one-offs" and that future economic downturns will not require interest rate adjustments to counter recessionary pressures, the increasing reliance on non-conventional policies like quantitative easing are, at the very least, worrisome given the Bank of Japan's fifteen year colossal quantitate easing failure.  The future Federal Reserve may find that it has to be even more creative if it has any hope of bringing the economy back from a recession.