The Fed’s Conundrum
By Nayyer Ali MD
The central bank of the United States, known as the Federal Reserve Bank, or simply the Fed, has been battling the effects of the Great Recession for eight years now.
Despite extraordinary policy measures, it has yet to fully engineer a strong recovery that would allow interest rates to return to “normal” levels. Instead, we have had seven years of short-term interest rates held at zero, with just the slightest uptick by a quarter of a percent late last year. 2016 was supposed to be the year that the Fed could finally start raising interest rates closer to normal, but instead it has stayed on the sidelines all year long as the economic news was too tepid to justify raising rates.
The Fed normally only controls the rate of interest charged to banks on short-term loans. That rate, the Fed Funds Rate, then impacts what banks charge customers who borrow money. These short-term rates also affect longer-term rates such as car loans or home mortgages. The lower the interest rate, the more fuel the Fed is supplying to the economy, as low interest rates make it cheaper for businesses to borrow for investment and for customers to borrow for purchases. In the past, what limited the downside of the Fed Funds Rate was that too low an interest rate would result in the economy expanding too quickly, and bottlenecks of available workers or capital would cause prices to rise which we would see as inflation.
On the flip side, if the economy is running too fast, and inflation is becoming a worry, the Fed raises interest rates high enough to choke off economic activity. In the last recession around 2001 the Fed cut rates down to 3%, then raised them back to 6% in 2007 just before the financial crisis. But in 2008 it rapidly cut rates to zero and has left them there.
The economy did slowly recover, but has not boomed. Instead, GDP has been growing a tepid 2% or so each year, compared to 4% per year during the last half of the 90’s in the Clinton boom years. So what can the Fed do to support the economy and get it back to its long-term trend? One approach it tried for several years was buying long-term debt in an effort to push down mortgage rates and make home-buying easier. That worked to some extent, and the Fed bought 2 trillion dollars of long-term US government bonds. This is why anyone who bought a house in the last five years has gotten very low interest rate mortgages. But it still hasn’t been enough. The program was called Quantitative Easing (QE), and it was bitterly criticized by Republicans because the Fed simply printed the money it used to buy those bonds. As the central bank of the US, they can print money when they want.
The Fed has asked for help from Congress, as the other way to increase economic growth is through government spending. If the Congress had passed additional stimulus spending in the last few years, perhaps another trillion dollars, it would have had to borrow that money. But interest rates are so low that it can borrow for 10 years at 2%, which means that trillion dollars in spending would only cost 20 billion in annual interest bill, and that would easily have been paid for by the taxes generated by the economic activity (infrastructure spending for example) of the stimulus. Unfortunately, the Republican Congress is obsessed with deficits and refuses to spend money while the economy is weak, which is what orthodox economics says you should do. Now if the GOP got control of the government they would cut taxes on the wealthy, and that would raise the deficit, but that wouldn’t bother them in the least.
The other option the Fed could try is something called “helicopter money”, a term coined by the economist Milton Friedman. He said that in a severe recession, the Fed could simply through money out of a helicopter as an effective way to increase aggregate demand and stimulate the economy. This is somewhat similar to QE, but instead of buying bonds and pushing down interest rates, the Fed prints the money (in reality, it’s all done electronically, no actual printing involved) and mails a check to every adult American. It could send 500 dollars per person every month till the economy took off from all the extra spending Americans would do.
Helicopter money seems like cheating, or a free lunch, but it actually would work. The trick would be to know when to stop before inflation sets in. Otherwise, there is no theoretical reason why it can’t work. If the Congress gave everyone a 2,000 dollar tax cut, and sent out a rebate check, it would have to borrow money to do that, but if the Fed then bought those bonds in QE manner, it would essentially be the same thing as helicopter money. While there have been a few voices that have suggested such a drastic step, the Fed has not seriously considered it, and it is not clear if it would have the legal authority to do such a thing even if it wanted.
The current Fed Chairwoman, Janet Yellen, last week confirmed that the Fed is frustrated by the slow pace of economic growth. The plans to raise interest rates back to normal remain on hold. In the last decade the Fed established that its inflation target was 2%, but it is not clear if that is a long-run average, or a ceiling. If it is meant to be an average, then we should have several years of 3% inflation to make up for the last 8 years with inflation running well below 2%. Yellen suggested in a recent speech that the Fed should let the economy run “hot” for an extended period of time before pushing up interest. If so, this means that rates may stay very low for another two years. We may get another quarter percent increase in December, but 2017 may see very little rate rise.
The current economic expansion has been going on since the summer of 2009. It looks like it may go on for several more years. Until the Fed decides to seriously tighten interest rates, we will not see another economic downturn.