For much of the post-financial-crisis era, U.S. Federal Reserve officials have held to a belief that they could get back to their old way of doing things. Growth would resume at a modest pace, annual inflation would climb to 2% and interest rates would gradually rise from near zero to a normal level near 4% or higher.
As they prepare to gather at their annual retreat in Jackson Hole, Wyo., officials are grimly coming to a view that it isn’t going to happen that way.
Growth in economic output appears stuck at a slow pace, with inflation vulnerable to undershooting the central bank’s target. The Fed, in turn, is starting to see that rates aren’t going to return to normal and the way it conducts monetary policy and deals with recessions is going to have to change.
“New realities pose significant challenges for the conduct of monetary policy,” San Francisco Fed President John Williams said in a research note released last week on the shifting monetary policy landscape.
In this world, unconventional tools used after the financial crisis—including purchases of long-term Treasurys to push down long-term interest rates and assurances of low short-term rates into the future—could be rolled out when another downturn hits. A portfolio of securities, now $ 4.2 trillion, could grow. Unpopular interest payments to banks for their deposits at the central bank could persist.
The new normal, in short, could look a lot like what the Fed has been doing for the past several years.
This isn’t to say the Fed won’t raise short-term rates again sometime this year. Many officials expect it will. The Fed boosted its benchmark federal-funds rate—a rate on overnight loans between banks—by a quarter percentage point from near zero in December. But it does mean it isn’t likely to raise them much beyond its next few moves in the months and years ahead.
“We probably don’t have a lot of monetary policy tightenings to actually do over time,” William Dudley, president of the Federal Reserve Bank of New York, told Fox Business Network.
Because growth is slow and could remain so, and inflation correspondingly low, the Fed has revised down its estimates of how high the fed-funds rate will go in the long run. Most officials see it reaching 3% or less. Four years ago the consensus was 4% or more.
A low rate in normal times puts the Fed in a bind when another recession hits. During the past four downturns dating back to the early 1980s, the Fed cut short-term rates by 5 percentage points or more in an effort to stimulate growth by boosting borrowing, spending and investing.
It now looks like it won’t have that room to maneuver next time. Officials will need to turn to other tools to support growth in a downturn. That includes bond purchases and assurances of low rates in the future.
The Fed’s last round of bond purchases—also known as quantitative easing, or QE—increased its securities holdings from $ 2.6 trillion to $ 4.2 trillion. A Standard & Poor’s analysis found that third round supported the creation of 1.9 million jobs and helped reduce the unemployment rate by 1.3 percentage points. “By that measure, QE3 worked,” S&P concluded.
Officials are wary of more radical measures. Mr. Williams said the Fed might need to consider raising its inflation target from 2% to 3%, an idea that hasn’t yet caught on with many others at the central bank.
Meantime, negative interest rates are seen by many Fed officials as a last resort that haven’t worked very well in places like Japan.
A research paper by Fed senior economist David Reifschneider argues that bond purchases and low-rate promises ought to be enough for the Fed to manage even a “fairly severe recession” that drives the unemployment rate up to 10%. Doing so would require the Fed to expand its securities portfolio by $ 2 trillion, and possibly as much as $ 4 trillion, the analysis shows.
Still Mr. Reifschneider warns “one cannot rule out the possibility that there could be circumstances in the future in which the ability of the [Fed] to provide the desired degree of accommodation using these tools would be strained.”
The Fed’s challenge goes beyond managing another recession.
The topic of the Jackson Hole meeting is “Designing Resilient Monetary Policy Frameworks for the Future.” Fed officials heard special briefings from staff at their July 26-27 policy meeting on related topics. In addition to the challenge of addressing recessions, it involves the shifting plumbing of how monetary policy is conducted in a low-rate world.
To manage its large securities portfolio and the abundance of reserves it has placed in the banking system, the Fed has rolled out new tools, including interest payments to banks on their deposits at the Fed. Lawmakers have complained to Fed officials that the payments look like an unfair subsidy to big banks.
In this brave new world of central banking, it is another feature of the current landscape that just might not go away.
Write to Jon Hilsenrath at [email protected]