In the Next Downturn, Fiscal Policy May Have to Step Up

Date : 12/08/2019 @ 3:29PM
Source : Dow Jones News

In the Next Downturn, Fiscal Policy May Have to Step Up

By Nick Timiraos 

The U.S. federal budget deficit recently surpassed $1 trillion. In the next downturn, don't be surprised if this number hits $2 trillion.

In the decades since British economist John Maynard Keynes proposed aggressive government spending to battle the Great Depression, Washington has usually injected cash into the economy through interest-rate reductions, tax cuts or ramped up spending when recession hits.

The central bank is likely to hold rates steady at its meeting Tuesday and Wednesday after cutting them three times this year to cushion the economy against a global growth slowdown amplified by the U.S.-China trade war.

It isn't news that the Federal Reserve has less room to counteract a recession by cutting its benchmark interest rate. In the past three downturns, the central bank has cut the rate by at least five percentage points. The Fed couldn't do that now because the rate is in a range between 1.5% and 1.75% and unlikely to rise soon.

What's less appreciated is that the unconventional tools the Fed deployed to stimulate the economy after the 2008 financial crisis -- bond purchases and so-called forward guidance about its plans to hold interest rates at very low levels for much longer than investors expected -- probably won't have the same power to spur growth in another downturn.

"You can use those tools to the hilt, but those tools operate primarily through one channel -- by bringing down long-term interest rates," said David Wilcox, former head of the Fed's research and statistics division. "Long-term interest rates are already too low by historical standards for those other tools to be fully capable of delivering the punch that will be needed to counter the next recession, no matter how hard the Fed pushes on them."

Fed Vice Chairman Richard Clarida drew attention to this problem in a speech last month. Global forces and the Fed's success in keeping inflation low and stable have contributed to ever lower long-term yields, he said.

The yield on the 10-year Treasury has hovered around 1.75% in recent weeks, and it has spent very little time above 3% this decade. Following the past two recessions, the yield declined by roughly 3.6 and 3.9 percentage points, respectively.

"I will confess that I think it highly unlikely in the next downturn, whenever it is, that 10-year U.S. Treasury yields will fall by" similar magnitudes, Mr. Clarida said.

The Fed cuts rates when economic growth is poor to encourage businesses and households to invest or spend. In the years after the financial crisis, with short-term rates pinned near zero, the Fed's other tools worked primarily by driving down long-term rates, which made it easier for households to pay off debts and encouraged new borrowing and risk taking.

Forward guidance was powerful because investors and the broader public didn't initially understand how the Fed planned to hold short-term rates at very low levels for much longer than they had after prior downturns.

In the next downturn, "it's not going to have the oomph that it did when we were brand new at all this, and folks just didn't get it," said economist Jon Faust at a 2016 conference at the Brookings Institution. Mr. Faust is currently a senior adviser to Fed Chairman Jerome Powell.

Where does this leave the Fed? Officials are engaged in a yearlong review of their recession-fighting tool kit. They are also weighing changes to their strategy of targeting 2% inflation to see how they might give monetary policy any more zip.

One option under active consideration and advocated recently by Fed governor Lael Brainard would be to experiment with capping yields on short-to-intermediate Treasury securities.

Instead of purchasing pre-announced quantities of bonds and notes, as the Fed did between 2008 and 2013, officials would commit upfront to buy whatever amount of securities was needed to hold rates at desired levels until they met their goals for inflation and employment.

Either way, many economists say fiscal policy will have to play a larger role. "The Fed is going to have one hand tied behind its back fighting the next recession," said Mr. Wilcox, who is now at the Peterson Institute for International Economics.

Without more help from fiscal policy, "recessions will be deeper and longer than they would have been under the circumstances that have prevailed until now during the post-World War II period," he said.

In congressional testimony last month, Mr. Powell tacitly acknowledged this. But he and other Fed officials have been reluctant to offer a prescriptive account of what might be needed.

Fed officials are reticent out of fear that would muddy the traditional separation between fiscal policy -- the product of often highly politicized debates in Congress and the White House -- and monetary policy, which the Fed tries to shield from partisan politics.

But the Fed's lack of tools makes it important, some economists and former central bankers say, for policy makers to discuss in the open now what the parameters for any potential coordination would look like.

"No matter what, when the next slowdown hits, we're going to be pushed in a direction where there is a blurring between the fiscal and monetary authorities," said Jean Boivin, a former deputy governor at the Bank of Canada who now works at money-management firm BlackRock Inc.

Addressing the issue now would help minimize these complications in an economic emergency, and it could restore investor confidence that policy might still have some recession-fighting power.

Write to Nick Timiraos at


(END) Dow Jones Newswires

December 08, 2019 10:14 ET (15:14 GMT)

Copyright (c) 2019 Dow Jones & Company, Inc.

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