Janet Yellen Fed rates rise
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The Federal Reserve has just embarked on its first interest rate-raising cycle for a decade, but that does not mean it is too soon to think about how it would resuscitate the economy if a new recession unexpectedly struck.

Janet Yellen, the Fed’s chair, on Wednesday said that recoveries do not “die of old age” as she dismissed suggestions that the US expansion was getting perilously long in the tooth six years after the Great Recession.

The chances of the US being hit by a shock that drives it into recession in any given year might be at least 10 per cent, but there was nothing to make her particularly concerned about a setback now, Ms Yellen said. Yet the chair also made it clear that the Fed has looked at the options that would be at its disposal if the US economy stumbled.

Doing so is only sensible: central banks around the world ranging from the European Central Bank to the Bank of Japan and Swedish Riksbank have lifted rates in recent years, only to be forced to cut them back after their economies faltered.

“We now have a playbook for this,” said Randall Kroszner, who served as a Fed governor during the crisis and is now at the University of Chicago Booth School of Business. “A number of central banks have raised rates and then had to retrace their steps. They have ended up cutting rates back, engaging in QE and in some cases taking rates into negative territory.”

The Fed on Wednesday kick-started what is likely to be the shallowest rate-hiking cycle since the 1970s, as it cautiously reins in the economic stimulus it inaugurated during the financial crash.

Even if policymakers’ median predictions are fulfilled — something the markets doubt — the fed funds rate will be barely above 3 per cent by the end of 2018, giving the Fed little room to cut before rates hit zero again if it needs to boost the economy.

Ms Yellen suggested on Wednesday that one of the reasons the Fed wants to keep the stimulus from its swollen $4.5tn balance sheet fully in place for some time to come is that this should give it greater scope to lift the federal funds rate, creating a bigger rate-cutting buffer if it needed to reverse course.

“One factor that we’ve talked about is the desirability of having some scope to respond to an adverse shock to the economy by lowering the federal funds rate,” she said at a press conference. “It would be nice to have a buffer in terms of having raised the federal funds rate to a certain extent, to give us some meaningful scope to respond.”

Lou Crandall, chief economist at Wrightson ICAP, said the strategy was logical. The Fed has “two dimensions along which it can tighten,” he said — one by allowing its balance sheet to shrink as assets mature and run off, and one by lifting rates.

If the US economy stalls, it would be simpler for the Fed to cut rates back than to restart asset purchases to bulk up its balance sheet. “Politically it is much harder to start [Quantitative Easing] again,” he said.

That said, if the Fed did have to lower rates back to near-zero, it would soon have to start thinking about alternative strategies to restart the economy — all of them fraught with difficulties. “There is a pretty good chance that the next recession we have the Fed will have to do something unconventional,” said Ethan Harris, co-head of global economics at Bank of America Merrill Lynch.

One of the options would be to cut rates into negative territory, something the Fed decided against during the last crisis because of fears of adverse repercussions in financial markets. Mr Crandall said the gambit could well be disruptive to the money market fund industry, prompting massive outflows.

Nevertheless, Ms Yellen has left it on the menu, following the recent experience of central banks in Europe including the ECB. “I don’t contemplate that we will need to do this, but it is something that we could study,” she said.

Whether it is a genuine option would principally depend on evidence of the effectiveness of recent negative rate policies abroad. The jury thus far is very much out, argued Mr Kroszner.

A more likely option would be doing more with the Fed’s balance sheet, as well as forward guidance to assure markets rates will be kept low. An initial step might be to shift the composition of the Fed’s portfolio towards longer-dated securities, in a re-run of the so-called “operation twist” that occurred under Ben Bernanke, the last Fed chair, said Mr Crandall.

That would be a very incremental move, however. The bolder step would be full-blown balance-sheet expansion, as the Fed boosted its stockpile of securities. While QE can be potent in helping calm a panic, some studies point to a relatively modest economic impact.

A more likely option would be doing more with the Fed’s balance sheet, as well as forward guidance to assure markets rates will be kept low. An initial step might be to shift the composition of the Fed’s portfolio towards longer-dated securities, in a re-run of the so-called “operation twist” that occurred under Ben Bernanke, the last Fed chair, said Mr Crandall.

“The Fed and the market would realise it would be a heavier lift to have the same impact as before,” said Mr Kroszner. “However that would not deter them from using QE if there were a significant downturn or a threat of deflation.”

As the central bank embarks on its rate increases, none of this appears to be an immediate concern. Once the Fed starts lifting rates, the process tends to keep going for some time, said Jim O’Sullivan of High Frequency Economics.

However he cautioned: “With growth pretty modest, it may take less of a shock than in the past to knock us over.”

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