The Fed's Real Question: Do We Go Negative?
As a result of downward market pressure on most asset classes and lower than expected May employment figures, the Federal Reserve Federal Open Market Committee (FOMC) voted 9-1 last Wednesday to maintain its policy rage of 2.25-2.50%.
Now to those that pay attention, this doesn't come as much of a shock (Futures contracts priced in a 20% likelihood the Fed would decrease rates during the meeting). However, what is surprising is how quickly the committee's economic outlook changed, as it was only last December when the FOMC forecasted two rate increases in 2019, and just March when the committee believed 2019 would close with an average target rate of 2.6%. Now it seems rate cuts are all but certain. So what exactly has the committee so spooked? Growth projections remain steady; consumer confidence is strong; and inflation expectations are only slightly lower than prior estimates. Why all the panic?
The reason is because elevated asset valuations, coupled with trade tensions with China, are causing many investors to trade as though a downturn is imminent. And the committee believes these pressures are strengthening to the point that if such "crosscurrents" continue, it may become a drag on the overall economy. Luckily, though, the Powell Fed seems rather hesitant to base its policy approach solely on market movements, because doing so is, as Alan Greenspan once quipped, "a lot like looking in the mirror," where traders react to the Fed and the Fed reacts to traders. So the committee, perhaps keeping Greenspan's point in mind, decided it’s best to keep a close eye on these developments and allow additional data to become available before making a decision whether or not to cut rates. And while some chastised the committee for its inaction, allowing more data to come available—specifically June employment numbers—is a reasoned approach when dealing with this level of uncertainty.
And sure, increased market volatility and deteriorating trade relationships are issues worthy of considerable attention, but neither should be the FOMC’s primary, near-term concern. The real test, and what should be on the mind of every FOMC voting member, is not what approach should be taken at the next FOMC meeting, or whether 2% inflation can actually be achieved given the current disinflationary environment, but rather what policy tools should be deployed when the next recession hits. Because, historically, the FOMC reduces the policy rate an average of 5% during recessions. However, with today’s low policy range of 2.25-2.50%, the committee has less than half the policy space in which to maneuver. And if there is a July rate cut, as Chairman Powell all but stated during his press conference, it will be even harder to fend off recessionary forces without venturing into negative interest rate territory. Hence the real question: is the Fed willing to go negative?
Now I imagine some of you reject my premise that US interest rates will hit zero, or maybe you think the Fed has developed new and improved policy tools that can be deployed if they do. But the reality is that if inflation doesn’t pick up, or economic growth slows enough to warrant significant action, policymakers may not have much of a choice. And as far as policy tools go, the non-traditional policy tools available today are pretty much the same as those that were available in 2008: large scale asset purchases (quantitative easing) and forward guidance.
So in the event where the US hits the lower bound, what should the Fed do? Should they venture into negative territory like Denmark, Sweden, Switzerland, and Japan—all of whom have had varied experiences with such policy— or should they rely on nontraditional policy tools to right the ship? It’s a tough question, and likely one that will remain unanswered until the FOMC is forced to address it. But if the committee refuses to go negative, nontraditional policy will need to play a major role in getting the economy back on a stable growth path. Let us not forget that at the start of the Great Recession, the fed funds rate stood at 4.24% — leaving the Fed more than 4 percentage points to cut before green-lighting quantitative easing. Today, we simply don't have that luxury.