The Federal Reserve will over the next several months make monetary policy decisions that are as consequential as any it has made since the financial crisis and Great Recession of 2007-2008. The temptation in a highly uncertain and politicized environment will be to move cautiously. Yet this would be a grave error in the current context, where a recession could be catastrophic and the odds of one beginning in the next year, while still less than 50-50, now appear significant and increasing.
While the headline number for first-quarter growth in gross domestic product (GDP) was a robust 3.1 percent, the details of the report suggest much weaker prospective growth. Jason Furman has highlighted that the gap between GDP as reported and the conceptually equivalent GDI, (gross domestic income) measure is now at its highest level since the onset of the Great Recession.
Moreover, the components of GDP that have predictive powerfor future growth are running at less than half the total GDP growth rate. Little wonder that most forecasters’ expectations for second-quarter growth are well below 2 percent. Other grounds for concern include weak reports from business on spending intentions, trade-war uncertainty and yield curve inversions —traditional predictors of recessions.
The best way to take out recession or slowdown insurance would be for the Fed to cut interest rates by 50 basis points over the summer and by more, if necessary, in the fall. A serious recession anytime in the next few years would encourage populism and polarization at home, and reduce American influence and strength in the world as well as damaging the global economy. It is clear in retrospect that the Fed was too slow in responding to gathering storms during 2008 as the Great Recession took hold and in 2000 when the Internet bubble collapsed.
Given that monetary policy operates with substantial lags and that downturns develop momentum once they start, monetary policy delay is always problematic when recession is a risk. For several reasons, slow Fed action would be especially dangerous in the current context.
First, markets currently expect rate cuts, so failure to deliver would be a negative surprise; it would have direct adverse effects and raise questions about whether the Fed is adequately sensitive to economic conditions. After the Fed unnecessarily raised rates last December, market gyrations and economic anxiety were contained when Chairman Jerome Powell signaled a dramatic change in policy, but the agitation illustrated what can happen when the Fed disappoints.
Second, the Fed normally cuts rates by a cumulative 5 percentage points in response to recession, and with rates now below 2.5 percent there is nothing approaching that amount available. Allowing a recession with inadequate firepower to confront it risks “Japanification” — a situation where interest rates are permanently pinned at zero and deflationary pressures take hold. The Fed will be able to do too little in combating the next recession, so it is especially important that it’s not too late.
Third, and perhaps most important, unlike the normal situation where the benefits of supporting the economy need to be weighed against the risks of allowing inflation, we are now in a situation where the Fed needs to accelerate inflation to meet its 2 percent inflation target. Core inflation on the Fed’s preferred indicator has come in at 1.6 percent over the last year and 1 percent over the last quarter. Moreover, market expectations as reflected in Treasury index bonds are for inflation on the Fed’s preferred measure to remain in the 1.5 range even over a 30-year horizon and to be even lower over shorter horizons. There is the further point that with a 2 percent inflation target, inflation during good times should run above 2 percent to compensate for its lower level during recessions.
Sometimes the Fed should worry that overly easy policy will lead to complacency in financial markets. In light of recent volatility in the markets and with the possibility of more adverse surprises on the trade front, this is not such a time.
If rate cuts by the Fed are seen as a capitulation to President Trump, this sort of pressure may be counterproductive, even apart from any long-term consequences. It would be tragic, though, if a lack of institutional self-confidence and a focus on appearances kept the Fed from doing what is best for the economy.