The Federal Reserve should use the same tools to fight the next recession that they developed during the financial crisis, even though the controversial strategies only achieved so-so results, according to a new paper released by a group of all-star economists Friday.
Global central banks won’t be able to rely on their traditional policy tool of slashing their benchmark interest rates to fight the next recession because rates are already low or negative.
The paper said policymakers should use some mix of tools, including:
• QE, or quantitative easing, which is buying assets and expanding the central bank’s balance sheet to push long-term interest rates down;
• Negative interest rates, to make it expensive for lenders to sit on cash;
• Forward guidance, or telling the market that rates would stay low for a specific period of time so that rates don’t spike at the first sign of a recovery.
• Yield curve control, which extends the maturity of interest rates that the central banks target.
Policies used during the financial crisis, some of which are part of this new prescription, were controversial. In the U.S., congressional Republicans strongly objected to the Fed’s QE programs, for instance.
The paper, which studies the crisis response in eight countries, stressed that some tools only worked occasionally, which central banks should bear in mind when fighting the next recession.
“Our results are decidedly mixed. Most of the time, new monetary policies were insufficient to overcome financial headwinds,” the paper concluded.
Policies proved powerful enough only about half the time in the United States, a little more in Europe and only rarely in Japan, the economists said.
About 20% of the time, the new tools backfired and financial conditions tightened. And in many cases, global conditions that were influencing policy were “insensitive” to individual central bank policies, they said.
Despite this checkered record, the economists said the central banks should double down and be more aggressive.
“We view the limited success in easing financial conditions in the face of global headwinds as a justification for more activist policy, not less,” the economists concluded. It was just important that central banks be humble about what results to expect, they added.
The paper was written by two leading private-sector economists, Michael Feroli of J.P. Morgan Chase, and Catherine Mann of Citigroup and three leading academics, Stephen Cecchetti of Brandeis International Business School, Anil Kashyap of the University of Chicago Booth School of Business, and Kermit Schoenholtz of the NYU Stern School of Business.
The analysis will be discussed at an all-day conference of top global central bank officials and economists, sponsored by the Chicago Booth School in New York later Friday.
The irony in the paper’s conclusion is reminiscent of a remark from former Fed Chairman Ben Bernanke, who once quipped that quantitative easing worked in practice but not in theory.
The economists noted that it was hard to measure the efficacy of the recession-fighting strategies. The tools were only used sparingly and during period of significant financial stress that economic models have a tough time capturing.
The paper recommended that the Fed clearly communicate its plan of action ahead of when the next recession hits because interest-rate policies work best when markets understand what the central bank is doing.
The most successful policy tool was when the central bank’s promise not to raise interest rates until a certain economic threshold was hit, the economists argued. In December 2012, the Fed announced it would not raise interest rates until the unemployment rate fell below 6.5%, a policy that had been advocated by Chicago Fed President Charles Evans.
Ultimately, the Fed didn’t raise rates until December 2016, eight months after the jobless rate fell below the 6.5% threshold.
The economists said it is unclear which tool should go first. And they were also uncertain whether using multiple tools at once was a better strategy than one-offs.
In many ways, the recommendations are not contrary to what the Fed has been saying.
Only last week, Fed Chairman Jerome Powell told Congress he would act aggressively to fight the next recession.
Bank of England officials have also talked recently about the need to act swiftly in the face of downside risks.
The Fed has been reviewing its recession-fighting plans as part of a broad review of its policy framework that was launched last year. Fed officials have said they intend to discuss the results of their review by the middle of the year.
Powell and other Fed officials have said they don’t support any plan to push the central bank’s benchmark interest rate into negative territory as European central banks and the Bank of Japan have done.
Some Fed officials have talked favorably about yield-curve control.
On a hopeful note, the paper said that the next recession might not be as severe as the financial crisis. But there is a strong chance that the next U.S. recession will coincide with a downturn in the rest of the world.
The 10-year U.S. Treasury note yieldTMUBMUSD10Y, -4.23% is in a range around 1.5%, well below a 3% level last seen in the fall of 2018.
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