Why the Fed’s Rethinking Its Toolkit (It’s Broken)

(Bloomberg) -- The world’s central bankers have a confession to make: They’re not sure whether the tools they’ve been using for decades work anymore. That uncertainty has become increasingly clear since the dramatic U-turn by the U.S. Federal Reserve in January, when it set aside plans to continue with a steady ratcheting up of interest rates. The persistence of economic fragility and stubbornly slow price increases, sometimes called lowflation, has central bankers wondering if they need a new toolbox — or a new compass.

1. What’s behind the rethink?

Here’s what’s puzzling the Fed and its counterparts: Since the 2008 financial crisis, policy makers have flooded economies with cheap money. As expected, that helped pull the world back from the brink of a global depression. It should also have produced robust growth and faster inflation – but it didn’t. To help it understand this new world better, the Fed has embarked on a year-long, wide-ranging review of its strategies, tools and communications practices.

2. Why did the Fed reverse course?

At the end of 2018, it looked like a global economic slowdown — or maybe even a recession — might be taking hold, even with interest rates at low levels. Fear roiled global financial markets as stocks tumbled in December. The Fed’s January about-face — dubbed the pivot — came just a few weeks after its policy makers said they expected to continue with gradual rate increases. In many other countries, plans to begin lifting rates from crisis-era levels were put aside before they could even kick off, while Europe and Japan have kept negative interest rates in place.

3. Wait — interest rates can be negative?

Yes. After the crisis, some central banks did something previously unthinkable: They pushed interest rates below zero, hoping that charging banks to hold onto their money would pressure them to get credit flowing again. U.S. officials discussed negative rates but decided against them. The European Central Bank is assessing whether the policy worked as intended.

4. So what’s the confusion about?

The big problem facing central banks today is tied up with a knotty concept called the neutral interest rate. That’s the rate that neither speeds up nor slows the economy. It only exists in theory — you can only estimate what it might be — but it’s what central bankers have in mind when they gauge how fast to let an economy run. They worry setting interest rates too low could set an inflationary spiral in motion.

5. What do they think the neutral rate is?

There’s been a growing suspicion it’s now lower than it used to be, for reasons that are unclear. A downward drift could mean a greater risk that when a central banks taps the brakes by raising interest rates — as the Fed did nine times since late 2015 — the impact might be bigger than it intends. That could mean slowing growth unnecessarily or even risking recession.

6. Where does this leave them in the meantime?

Watching for inflation. Economists think a modest amount of it is a good thing, partly because it gives them more room to move interest rates around. Today’s central bankers were heavily influenced by a dictum from Milton Friedman, the Nobel Prize-winning economist, that “inflation is always and everywhere a monetary phenomenon.” That leads them to the conclusion that if the inflation rate is low, central banks must not be pumping enough money into the economy. That’s why data showing inflation waning led the Fed to cool on higher rates. It also reconsidered plans to unwind its massive, decade-long bond-buying campaign.

7. So it’s not just about interest rates?

No. The Fed unleashed a program of bond buying, called quantitative easing, or QE, in 2008. It was followed by similar moves at the Bank of England, the ECB and the Bank of Japan. Altogether, more than $12 trillion was pumped into the financial system with the goal of making credit cheaper for everything from mortgages to auto loans.

8. What happened to QE?

The Fed stopped buying bonds in 2014. In 2017, it began what some called quantitative tightening by allowing its portfolio to gradually shrink. But it will halt the drawdowns in September to make sure it leaves enough money in the system. The ECB’s program ended in December though it is maintaining the size of its holdings by reinvesting payments from maturing securities. The BOJ is still buying bonds though it has tapered its purchases.

9. Why such focus on inflation?

Too-high inflation used to be what kept central bankers up at night, but now they’ve got the opposite problem. Officials in Europe and Japan have been concerned with the threat of actual deflation. Falling prices might sound good for consumers but central bankers fear them because they believe inflation-adjusted -- or “real” -- interest rates are what matter most for economic activity. That means when prices go down and nominal rates stay the same, real rates have gone up, making monetary policy tighter. In the U.S., even after a decade of economic expansion and despite the lowest unemployment rate in 49 years -- two factors that generally fuel wage and price increases -- inflationary pressures remain too weak for comfort.

10. Is managing inflation the main mission?

Pretty much, although the Fed also has a mandate of promoting employment. Central banks were originally set up to ensure financial stability following a series of banking panics in the 19th and early 20th centuries. After the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s and the inflation that followed, many central banks adopted Friedman’s world view and made price stability their central preoccupation. That led to the proliferation of a system known as inflation targeting -- explicitly aiming to keep prices going up by a small amount each year.

11. How does that work?

It’s thought to focus the public on a specific number, anchoring their expectations. Many central banks have adopted a formal 2% target. Since the Federal Reserve joined the club in 2012, however, it has pretty much consistently missed on the low side. Some economists argue that both inflation and interest rates should be higher than that, to give central banks more ammunition in the form of interest rate cuts during downturns.

12. What’s the big fear?

If there’s one thing many central bankers agree on, it’s the need to avoid what’s become known as Japanification. Interest rates there have been near zero or below since the 1990s, when the bursting of a property bubble left decades of sluggish economic growth in its wake. Japan’s central bankers have taken quantitative easing further than anyone else, but inflation there is still running below 1%.

13. Is inflation dying?

That’s the question. No one really knows why it has failed to return. Possible causes include globalization, which has brought millions of low-wage workers into labor markets, along with market concentration and the decline of labor unions, both of which undermine the power of workers to demand higher wages. Some critics worry that central bankers preoccupied with lowflation will keep interest rates too low for too long and fuel bubbles in financial markets. Others think central banks are being too timid, and should be cutting rates to goose growth enough to produce the wage gains that are inflation’s fuel. One such critic lives in the White House.

14. Why’s Trump trashing the Fed?

As the Fed raised rates, U.S. President Donald Trump became increasingly unhappy. Even after the January pivot, Trump has continued to rail against it to his 60 million followers on Twitter, setting up Fed officials to take the blame if things go wrong with the economy. His appointees to the Fed’s rate-setting board, including Chairman Jerome Powell, backed the rate hikes. In early 2019, Trump had two more seats to fill, and has considered people who think more like he does.

15. Are central banks losing their mojo?

Not just the Fed, but central bankers in most of the world enjoy a privileged status as the primary managers of the business cycle, and in most cases even have formal independence within the government bureaucracy. That’s based in part on widespread acceptance of the idea that central banks should be shielded from the pressures of day-to-day politics so that they can take a longer view and make unpopular decisions if needed. But the difficulties central banks are encountering in stabilizing the economy has led more of them to concede that fiscal policies, such as changes in taxation and government spending, should take on a larger role, as was the case before the 1970s.

16. So spend more?

Perhaps. To former U.S. Treasury Secretary Larry Summers, the best medicine would be spending on infrastructure and other projects to boost productivity. Spending is also the crux of a once-fringe idea known as Modern Monetary Theory being embraced by some in the Democratic Party advocating for more money for the environment or other issues. It boils down to the appealing argument that with inflation in check, the U.S. can step up spending without worrying about budget deficits because it can always create more money to pay debts. To mainstream economists like Summers who worry the policy could ignite runaway inflation or debase the U.S. dollar, it’s a reckless view.