How new Fed Chair Jerome Powell should get ready for the next recession
New Federal Reserve Chair Jerome Powell testified before Congress this week, roughly a month after replacing Janet Yellen. The key question many have is whether or not a change in personnel will mark a break with past policy. If it does, and if the Fed starts crediting arguments for raising interest rates that they correctly rejected before, then today’s low unemployment rate might be unfortunately short-lived.
Under Yellen’s leadership, the Fed was notably “dovish” in that it strove to keep monetary policy expansionary with the goal of pushing unemployment down, rather than contractionary in the service of guarding against an outbreak of inflation. Her replacement, Jerome Powell, served on the Fed’s Board of Governors with Yellen between 2012 and early 2018. Powell was by most accounts supportive of the policy path blazed by Yellen, so in that sense a radical change in the Fed’s stance would be surprising. But Yellen wasn’t just a dovish vote on the Fed, she was an intellectual leader in the defense of expansionary monetary policy over the past decade. As a highly respected academic macroeconomist and policymaker, Yellen had the ability and confidence to push back hard on weak arguments about why the Fed should reverse course and begin worrying about containing inflation rather than pushing down unemployment.
One of these weak arguments is that the Fed needs to raise rates faster and sooner so that when the next recession hits, there will be enough “room” to lower them. Proponents of this argument point out that in previous recessions the Fed lowered the short-term “policy” interest rates that it controls by 3–5 percentage points in an effort to restart growth. Today these rates are at 1.5 percent, and, they really can’t go much below zero for any extended period of time. This “zero lower bound” (ZLB) on interest rates is driven by the fact that once these rates hit zero, wealth-holders will just stop demanding bonds and will be happy to hold cash instead. This means that further Fed purchases of bonds to lower rates will have no effect. What hitting the ZLB means for policy is that we could enter the next recession without the ability of the Fed to lower policy rates as far as they have in the past.
While the constraints put on monetary policymaking by the ZLB are real, raising rates now to clear out room for cutting them later remains a silly idea. First, raising rates sooner and further doesn’t just give the Fed more interest rate “room” to fight the next recession, it also makes the next recession more likely. Post-war recessions have largely occurred because of asset market bubbles popping or the Fed raising rates too far and too fast.
An analogy might help point out the absurdity of this. Say that your house is a cool 50 degrees and you hike the thermostat to your desired temperature of 70 degrees. After the heat has been running for a while, the house has warmed to 60 degrees, and your roommate argues you should turn the thermostat off because if the room gets really cold again, you’ll want “room” to warm it by cranking the thermostat up again.
Does this make sense? Of course not. So long as one believes that the economy has not warmed up to its optimal setting, then one should not be using policy tools to cool it back down. Is there a convenient summary measure that can guide us as to whether or not the economy is running hot enough? There are lots, actually, but let’s use the Fed’s own announced measure: 2 percent price inflation. The economy has been running beneath this 2 percent inflation target for years now, and there is little evidence of any acceleration. Further, if one excludes rental prices, then inflation has been even lower. Fighting rent inflation (which occurs due to low supply of housing units relative to demand) by raising interest rates which will curtail home-building would be perverse.
So, the economy is by the Fed’s own definition not running hot enough, yet they’ve already begun raising rates to cool it off, backed in part by arguments that this is necessary because one day they might want to try to heat it back up. This is a terrible way to prepare for the next recession.
What’s the obviously better way to prepare for the next downturn? Keep heating up the economy until you hit your own stated price target! If the economy begins slowing and the Fed decides to lower policy rates, these rate cuts will have much more traction if inflation is higher rather than lower. Real (inflation-adjusted) interest rates are what drive investment and consumption decisions, and higher inflation expectations (all else equal) pushes down these real rates. Further, if we enter the next recession with the Fed having never hit its own inflation target, their credibility for ensuring people that downturns will not be allowed to pull down inflation in the long-run will be severely damaged. This means that the next recession could see expectations of inflation fall precipitously, with real interest rates rising in response just as the economy needs lower, not higher rates.
Job number one for the Fed in preparing the economy for the next recession is re-establishing the ability to hit their own inflation target. This is by far the smartest way to generate room for (inflation-adjusted) interest rates to be cut as we enter the next recession. The way to hit this inflation target is to keep rates down until you have hit it. Raising rates while at the same time telling people you’re committed to nudging inflation higher makes no sense—like turning down the thermostat while telling people you’re committed to a warmer room. Further, nothing about this argument changes because of the boost to fiscal stimulus provided in recent months. This fiscal stimulus is likely to nudge the economy more quickly to the Fed’s inflation target than it would otherwise have reached it, but we just don’t know exactly when that would be, and Powell and the Fed shouldn’t assume they know either, and should be guided by actual movements in inflation.
Finally, calling on the Fed to do harmful things in order to have room to reduce short-term policy rates during the next recession seems to be willful denial that the economy has changed, and that the ZLB is likely to be with us for a long time. Policymakers just need to figure out tools that will work to stimulate the economy even when short-term interest rates are at zero. Fiscal stimulus is the most obvious economic answer. But the Fed has tools to lower long-term rates directly and could do that. Entering the next recession with a higher inflation target is another smart way to deal with the zero lower bound. And thinking big about ways to let the Fed actually give money to households rather than just swap financial assets with banks would be a good thing to start thinking about as well.
But, as new Fed chair Jerome Powell weighs arguments about the policy path he’ll chart over the coming year, he should absolutely ignore calls to “get ready for the next recession” by pursuing too-rapid interest rate increases that will make the next recession more likely. Instead, he should communicate—by keeping rates low—that he’s determined to at least hit the Fed’s 2 percent inflation target that they’ve defined themselves as defining a well-heated economy. A key legacy of the Yellen era was ignoring bad arguments mobilized to urge a too-austere Fed. Powell should try his best to make this one of his legacies as well.