Timothy Lee points Yellen the way

The next recession could be around the corner, and the Fed isn’t ready for it:

Around the world, markets are in chaos. Japan’s stock market plunged 5 percent on Friday, while markets in France, Germany, and the UK all saw big losses on Thursday. The US stock market is doing better than most, but it is also down since the start of the year. Oil hit a new low on Thursday of $26 per barrel.

These declines reflect growing concerns that the world economy is headed for another recession. Before 2007 we’d say “if things get bad, the Fed will cut interest rates.” But with the Fed’s benchmark rate below 0.5 percent already, a substantial cut would mean rates that are below zero. That’s an unorthodox strategy, and it might not even be legal, according to testimony by Fed Chair Janet Yellen before congressional committees this week.

The Fed needs a new strategy: Stop targeting interest rates and instead target the growth of the overall economy. Moving away from interest rate targeting would give markets confidence that the Fed has the tools to deal with the next economic downturn, which would reduce the danger of another 2008-style meltdown.

Unfortunately, there’s little sign that the Fed is laying the groundwork for a shift in strategy. Instead, Yellen seemed to be in denial about the magnitude of the challenge she is facing.

“Let’s remember that the labor market is continuing to perform well,” Yellen said to the Senate Banking Committee on Thursday. “We want to be careful not to jump to a conclusion about what is in store for the economy.”

Maybe not — but the Fed needs to be prepared for the worst.

And…

So even if the Fed adopted negative rates, it wouldn’t improve the effectiveness of the current interest rate targeting regime very much. Just as the Fed got stuck at zero percent interest rates in 2008, it could get stuck at -1 percent interest rates in 2017 or 2018. So the Fed is going to need a new framework that’s less dependent on interest rates regardless. It might as well get started.

The chart illustrates that:

  1. Don´t lose the “target trend”
  2. If you do, try to get the economy back on it as soon as possible
  3. If you demure, it will become harder and harder to do it. You´ll have to be satisfied with an increasingly partial recovery!

Tim Lee

Naturally, if you wait too long, the present trend level will become the “new normal”!

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