Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

The Fed Should Embrace the Power of Straight Talk

(Bloomberg Opinion) -- In theory, the Federal Reserve has the tools to prevent (or at least mitigate) the next recession. In practice ... well, it’s complicated. That’s because the Fed will have to rely on something it has not quite mastered: its communications skills.

Over the last few weeks, my Bloomberg Opinion colleagues have been discussing how central banks can respond to the next recession. Its timing isn’t an idle question — global growth is weakening, with the effects of China’s slowdown weighing on Europe. So far U.S. growth has remained strong, but the U.S. economy cannot remain uncoupled from the rest of the world forever. At the same time, the stimulating effects of the recent tax cuts are beginning to wear off, and the U.S. housing market is cooling off.

The Fed’s primary method for combating recessions has long been to cut interest rates, which translate into additional spending to help support the economy. But with the Fed’s target interest now hovering around 2.5 percent, there isn’t much room to cut.

That means the Fed will almost certainly have to turn to quantitative easing in the event of a new recession. From November 2008 to October 2014, the Fed purchased more than $3.5 trillion in Treasury bonds and mortgage-backed securities as a part of three so-called QE programs. How much effect this had on the economy is the subject of intense debate.

On the one hand, economic theory suggests that the effects of QE should be quite mild. The Fed is buying up a lot of assets, particularly Treasury bonds, but it’s paying for those assets by issuing interest-bearing reserves to banks. Decreasing the circulation of one government asset (Treasury bonds) while increasing the circulation of another (bank reserves) shouldn’t affect the financial system that much, let alone the whole economy.

Yet the announcement of the QE program had clear positive effects on the stock market and seemed to coincide with an increase in investor confidence. Wall Street certainly believes that QE increases asset prices, if nothing else. And rising asset prices can stimulate economic growth. This suggests that QE can have a positive economic effect.

My own view is that QE works by setting expectations. It tells the market that the Fed intends to make it easier to get short-term loans. That makes investors a bit more willing to take risks, since they know that if they get in trouble, then at least over the short term, they will be able to borrow enough money to make the necessary payments to creditors. The same basic theory holds true for businesses, where a greater willingness to take risks can sometimes (though not always) lead to more jobs and a stronger economy.

All of which leads to a serious question: If QE works at least in part by setting expectations, then can the Fed transmit those intentions with words instead of money?

Here’s where the complications come in. The Fed meets twice each quarter. After each meeting it releases a formal statement and provides supplementary materials, and hosts a press conference with Chairman Jerome Powell. The goal is to give the public as much information as possible about what the Fed is thinking.

Unfortunately, with so much information, the message is often muddled. When this happens, markets can react suddenly and negatively, as they did following Powell’s press conference last December, causing widespread anxiety among investors and consumers alike.

The Fed can simplify its message — and its task — by setting an overarching goal: Keep spending growing along a relatively smooth and stable path. If the economy begins to overheat and inflation starts to pick up, then spending will start to rise above this path. Markets would then understand that the Fed’s next moves will be aimed at slowing the economy down.

If, on the other hand, the economy enters a recession, then spending will fall sharply below this path. Until spending starts to catch up, markets will know that the Fed intends to stimulate the economy by making short-term funding easier.

This type of straightforward communication would avoid any confusing signals. It would also allow the Fed to retain the flexibility to make course adjustments as necessary. Most important, establishing a clear path would give the Fed the power to set well-defined long-run expectations. That’s a power it will almost certainly need if the economy falls into recession anytime soon.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

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