Lower interest rate depletes monetary policy buffer
In his keynote delivered at the tenth conference organized by the International Research Forum on Monetary Policy in March, Boston Federal Reserve president Eric Rosengren highlighted US policy tools’ deficiency in combating another recession. Speaking about the monetary policy tools, he said that the current level of US short-term interest rates (SHY) leaves little room for them to be lowered during an economic slowdown. In an economic slowdown, central banks’ first line of defense is often to increase system liquidity by lowering interest rates.
History of US interest rates
The US Federal Reserve, in its attempt to spruce up the economy after the Great Recession, lowered interest rates to close to 0% and kept them there for some time. The Fed started lowering interest rates (BSV) after the subprime mortgage (MBB) crisis in August 2007, bringing the rate from 5.5% in August 2007 to ~0% by December 2008 as the economy struggled to pick up. The first rate hike after that came in December 2015, and the Fed has so far increased interest rates six times, with the last hike announced at its March 2018 meeting.
The problem with the current interest rate
Rosengren argued that the current US interest (BND) rates are too low, and the buffer they provide in times of economic slowdown might not be sufficient. He suggested that a higher interest rate would offer sufficient wriggle room to combat any future recessions. This view bodes well with the current rate projections from the Fed, which, in its recent summary of economic projections, indicated that there would be two more hikes in 2018 and three hikes each in 2019 and 2020. Even then, rates would still be below pre-recession levels. The new normal rates could remain low as long as inflation (TIP) remains stable and the unemployment rate remains low. In the next part of this series, we’ll analyze Rosengren’s views on US fiscal policy.