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The Federal Reserve’s ability to fight future recessions is under serious threat. The macroeconomic environment has changed in a way that could handcuff the Fed the next time the economy weakens. The clearest symptom of that change is that even though the labor market is very strong by historical standards, the interest rate that the Fed controls is just below 1.25 percent.
That’s a big problem. If the Federal Reserve does not decisively change the way it conducts monetary policy, future recessions will be longer and deeper than they need to be.
However, it is within the Fed’s grasp to meaningfully improve the situation. In a Peterson Institute Working Paper, David Reifschneider and I lay out a program that would go a long way toward restoring the Fed’s recession-fighting ability. That program would have the Fed commit now—while the economy is still strong—to conducting monetary policy in a much more aggressive way the next time the economy goes into recession.
How do we know that the Fed urgently needs to change its basic approach? In battling each of the past several recessions, the Fed cut its policy interest rate by more than 5 percentage points. But with rates already so low, interest rate cuts of that magnitude will not be possible the next time recession strikes. Longer-term rates also are historically low—a factor that further limits the Fed’s recession-fighting capability.
The Fed is fully aware of this threat. Indeed, motivated importantly by the constraints on its recession-fighting capability, the Fed is reassessing the way it conducts monetary policy. By undertaking this “framework review,” the Fed has created a rare opportunity for systemic change. It is imperative that the Fed make the most of this opportunity and take bold steps to strengthen its ability to fight future recessions. In particular, we recommend the following:
- First, the Fed should commit that, once it has run out of room to cut its policy rate further, it will keep the policy rate at its minimum level until the labor market has fully recovered and inflation has returned to 2 percent. Moreover, the Fed should promise that once those two threshold conditions have been met, it will raise its policy rate much more gradually than it would have done in the past.
- Second, the Fed should commit that, under the same circumstances, it will begin buying longer-term assets at a steady and sizeable pace and will continue buying until the labor market has fully recovered. This second step will allow the Fed to put additional downward pressure on the longer-term interest rates that play such a key role in determining financial conditions more broadly.
To make the new framework fully effective, the Fed will need to communicate clearly about what it’s committing to and when it will consider easing up on the accelerator. Vague language and unclear commitments will undermine the effectiveness of the new framework.
Model simulations reported in the working paper corroborate the view that if the Fed can establish the credibility of the two commitments outlined above, the new framework would restore much of the policy space that has disappeared as a result of the changed macroeconomic environment. In fact, if enough factors break in the right direction, these steps might allow the Fed to fight the next recession as effectively as it would have a few decades ago.
However, things might not work out that well. If the next recession is unusually severe, or the tools of monetary policy turn out to be less potent in the future than generally believed, or the normal level of interest rates declines further, the Fed will run out of countercyclical firepower. Even if none of these things goes wrong, there will be no margin of safety.
Therefore, two other steps should be taken now. First, the Fed should raise the target rate of inflation from 2 to 3 percent and should announce that it will revisit the inflation objective every five years. Raising the inflation target would be a controversial step. Because we think it is so important that the Fed take that step, we will lay out the case for it in a future paper. Second, Congress and the president should fortify the ability of fiscal policy—think, taxing and spending policy—to help fight the next recession. Plenty of practical ideas have been identified for how this could be done; these ideas should be put into law.
Losing a job can feel like a Great Depression to the person suffering the loss. Policymakers should move boldly to make that devastating experience as rare as possible.
