Fed’s Rosengren sees less room to tackle next recession

Fiscal, monetary and regulatory buffers are not as high as they should be, says Boston Fed president
Eric Rosengren

Policy-makers in the US may have limited room to respond to the next recession due to a failure to build buffers during good times, Eric Rosengren warned on September 8.

“We don’t have much monetary policy ammo, in the event that we do have a recession,” the Federal Reserve Bank of Boston president said at a conference his institution was hosting.

But Rosengren also warned that Federal and regional fiscal buffers were likely insufficient, as well as regulatory buffers. “Those buffers have actually diminished at a time when we would like to see them get bigger, and the result is, in the next recession we probably won’t have as much policy flexibility as we would like,” he said.

Rosengren was presenting the results of a paper, Some unpleasant stabilization arithmetic, co-authored with fellow Boston Fed economists Joe Peek and Geoffrey Tootell. The title may be a nod to a 1981 paper by Thomas Sargent and Neil Wallace, which questioned the long-run potency of monetary policy.

In line with earlier research, the paper notes the low neutral rate of interest is likely to constrain monetary policy, as rates will be close to the effective lower bound. But it also weighs up “non-monetary” buffers, and tries to estimate how resilient different US states would be to a new recession.

The US economy has been growing rapidly, hitting an annualised rate of 4.1% in the second quarter of 2018, though compared with the same quarter of 2017, growth was a more moderate 2.9%. Some commentators have warned the cycle may soon turn, citing the recent narrowing gap between short- and long-term yields, which has been a reliable predictor of previous recessions.

Rosengren, Peek and Tootell say the limited space for monetary policy to respond to the next recession calls either for the build-up of bigger monetary buffers, or greater action by the non-monetary authorities.

The paper recognises that any recession is likely to affect states in different ways. For example, a young population that is highly dependent on credit will be more affected if monetary policy cannot lower interest rates and if banks cut back sharply on credit.

“Even though we think of monetary policy as being a national policy, insofar as the federal funds rate applies to the entire country, its effects can differ across geographic regions,” the authors say.

The authors estimate the effects of a recession on each state, and then run the same model with monetary policy constrained by the zero lower bound. Some states suffer heavily in both cases, such as California. But the pattern of most-affected and least-affected states changes.

The effects of the recession could be “further magnified” if non-monetary buffers are depleted, the authors warn. “From a policy perspective, more attention should be given to establishing appropriate policy buffers to mitigate future shocks.”

State and federal governments ought to repair their financial capacity, the authors say, while banks must remain well-capitalised. Monetary policy-makers either need to create more space between the policy rate and the effective lower bound, or work out how to use non-traditional tools more aggressively.

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