The New Economic Normal and the Impact on the Federal Reserve

A recent speech by Eric Rosengren, President of the Federal Reserve Bank of Boston, gives us a glimpse of what may lie ahead in the world that is the Federal Reserve.  In his speech, he outlines why it will be necessary for the Fed to implement one aspect of its new monetary policy ammunition and why this will be necessary.

As we all know, the Fed and its most influential peers have kept interest rates at historically low levels for the longest period in history as shown here:

Obviously, when the next recession hits, the Federal Reserve will have very little room to drop nominal interest rates, particularly when looking at how much rates dropped in the past as shown on this table:

In real terms (i.e corrected for inflation), the Federal Funds Effective Rate has been in negative territory for the longest duration since the 1960s as shown here:

Mr. Rosengren notes the following:

1.) with today's ultra-low short-term interest rates, there will be a limited buffer for monetary policy to respond to economic slowdowns (i.e. central banks have not got sufficient room to lower interest rates as they have in the past). 

2.) real short-term federal funds rates are likely to be negative more frequently.

3.) nominal federal funds rates are likely to reach zero more often (and in my opinion, may become negative).

The economic problem that the Fed has faced since 2008 is structural rather than cyclic in nature, that is, the functioning of the economy has transformed in a manner that is permanent.  In other words, very little of what the Fed has done since the Great Recession has been effective because the Fed's policies are designed to deal with cyclic (temporary) changes in the economy.

Here are two examples showing how the economy has undergone structural changes:

1.) Productivity Growth - Change in non-farm real output per hour:

2.) Civilian labor force growth rate (i.e demographic changes):

So, what's a central banker to do when the next recession arrives?   Here's a hint:

The world's three most influential central banks have massively increased the nominal size of their balance sheets because they discovered that, in the wake of the Great Recession and the nature of the post-recession economy, simply lowering interest rates were "...insufficient to rekindle economic growth..."

Here's the same data as a percentage of GDP showing how desperate the situation is for Japan, a nation that has undergone the most profound demographic changes:

Mr. Rosegren states that "...structural changes in the macroeconomy may necessitate more frequent use of large scale asset purchases during recessions.  This latter view hinges on the argument that the combination of low inflation, low rates of productivity growth and slow population growth may imply an economy where normal or equilibrium short-term interest rates remain relatively low by historical standards, even once the economy has fully normalized."

As I've noted in the past, central banks have painted themselves into a policy corner from which there is no easy extrication.  Never before in modern history have central banks acquired such a massive inventory of assets and never before have they faced divesting themselves of these assets.  No one understands the market implications of unloading and offloading trillions of dollars worth of bonds, and yet, Mr. Rosengren suggests that expanding central bank balance sheets is the only way to stimulate a contracting economy in a low interest rate environment.  Keeping in mind that the world's central bankers didn't see the looming Great Recession until it was on the doorstep, we should be concerned that the repercussions of their remaining monetary policy tool is unproven.

Let's close this posting with Mr. Rosengren's concluding remarks:

"While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns. Unless productivity growth and demographic trends change, or monetary policymakers set a higher inflation target, the feasible reductions in short- term rates to combat recessions will not be sufficient. Thus, monetary policymakers are likely to need to use balance-sheet tools.

If monetary policy is to rely primarily on short-term interest rates to normalize policy, as seems prudent given the historical experience, in my view the Federal Reserve should adopt balance sheet exit strategies that reinforce the primacy of interest rate policy. Starting to shrink the balance sheet earlier – and doing so in a very gradual fashion – implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank’s balance sheet. This, in turn, will allow policymakers to focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy." (my bold)

Good luck with that, Mr. Rosegren.