Should the Fed be sweating zero lower bound?

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With the fed funds rate target cut to a range of 1.50% to 1.75%, there is concern that the Federal Reserve won’t have enough firepower to respond to the next economic shock.

In a speech on Monday, Federal Reserve Bank of Boston President Eric Rosengren expressed that concern, saying “policies and tools that may have been appropriate in a high interest rate environment will likely not be sufficient in the current environment.”

Now is the time to prepare for the next downturn, whenever it comes, by reexamining “other economic buffers.”

Without new buffers from “fiscal, regulatory, and financial stability policies and deemed appropriate to utilize by policymakers,” Rosengren said, future recessions could be worse than in the past and recovering could be “slower.”

“For several reasons, a low interest rate environment makes it more difficult to exit recessions,” he said in prepared remarks for delivery in Oslo, Norway. “This difficulty is due not just to the smaller monetary policy buffer, but also to the fact that a low interest rate environment encourages greater household and firm leverage that will amplify the severity of a downturn, should it occur.”

Peter Ireland, a professor of economics at Boston College and a member of the Shadow Open Market Committee, said Rosengren's concern is legitimate.

“With both the federal funds rate and the 10-year Treasury rate below 2%, there's just not a lot of room for the Fed to use traditional interest rate policies to stimulate the economy if we again fall into a deep, deflationary recession,” Ireland said. "The fact that the Federal Open Market Committee “really hasn't articulated any specific strategy that it might follow if the funds rate once again approaches a range near zero” also poses a concern, he said.

While quantitative easing, including forward guidance and asset purchases, will be in the mix, Ireland said, “the effectiveness of those measures might be enhanced if the FOMC helped market participants anticipate what it will do in advance.”

Ireland said, however, that a recession doesn’t appear imminent, as the Fed’s adjustments “appear to have had their desired effect in helping the economy pull through the rough patch we had earlier this year.”

Consumers are propelling the economy as the labor market remains “robust,” he said. “Some of the political risks associated with U.S.-China trade tensions and with the slowdown in global growth seem to have mitigated in recent weeks.”

While Ireland expects the Fed to remain on hold for now, “by this time next year, they may be ready to start raising rates once again.”

The Fed’s decision to “wait and see” at this point, “is a nod to the limited room to maneuver interest rates and a reflection that rate cuts must be employed judiciously," said Greg McBride, chief financial analyst at Bankrate.com.

"The Fed's position has been 'an ounce of prevention is worth a pound of cure' — essentially that cutting rates now will sustain the economic expansion and alleviate the need for even more cuts later," he said. But not everyone agrees, with Rosengren and Federal Reserve Bank of Kansas City President Esther George opposing the cuts. “Only time will tell who is proven correct and the efficacy of monetary policy is assessed only in hindsight," McBride said.

While “the recession hype seems to be dying down,” Michael Reynolds, investment strategy officer at Glenmede, is confident in the quantitative easing strategy.

“The Fed’s balance sheet has become an important tool that they will likely engage again in an adverse economic environment in the form of quantitative easing,” Reynolds said. “The Fed had the opportunity in the midst of the Global Financial Crisis to hone this tool and work out the operational processes, so they should be able to deploy this type of stimulus in a more timely, proactive fashion going forward.”

But the economy seems to be improving, and “our base case is that this record-long economic expansion has further room to run from here, though we are recognizing that lingering uncertainty over the U.S.-China trade relationship remains a headwind,” Reynolds said.

Not everyone agrees. “We continue to believe that economic growth is slower than generally expected and that there is a good chance we will go into a recession next year,” said Charles Self, chief investment officer at iSectors.

Self says the aggregate weekly hours worked is a better measure of labor health than the unemployment rate. “When things are slowing down, [employers] just reduce overtime and other hours to their current employees.”

Year-over-year aggregate hours worked is nearly flat, he said. “Historically, when this measure gets to current levels, we are only months away from the beginning of the recession. It makes sense, since workers are getting fewer hours, which leads to less consumer demand for goods and services.”

Should holiday sales be “tepid,” Self said, the Fed may need to “lower rates further in 2020's first quarter.” He said he expects the next Fed move will be a cut.

Craig Kirsner, president of Stuart Estate Planning Wealth Advisors, said he’s “100% worried about hitting ZLB!” In the two most recent recessions the fed funds rate was “much higher,” giving the Fed “much more ammunition to lower interest rates when the economy hit recession.” Now, the Fed will be at ZLB in six more cuts. Plus, “we have the Fed's ‘non-stimulus’ stimulus” as they “bail out the overnight repo markets to the tune of over $60 billion a month.”

Small business optimism
The National Federation of Independent Business’ small business optimism index rose to 102.4 in October from 101.8 in September.

“The economy will likely remain steady at its current level of activity for the next 12 months as Congress will be focused on other matters, and an election cycle will limit action,” according to NFIB Chief Economist William Dunkelberg. “Any significant change in trade issues will impact financial markets more than the real economy during this period. Adjustments to a new set of ‘prices,’ such as tariffs, will take time.”

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Monetary policy Economic indicators Eric Rosengren Jerome Powell Federal Reserve Federal Reserve Bank of Boston FOMC
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