Big Danger at the Lower Bound

CAMBRIDGE – Markets nowadays are fixated on how high the US Federal Reserve will raise interest rates in the next 12 months. This is dangerously shortsighted: the real concern ought to be how far it could cut rates in the next deep recession. Given that the Fed may struggle just to get its base interest rate up to 2% over the coming year, there will be very little room to cut if a recession hits.

Fed chair Janet Yellen tried to reassure markets in a speech at the end of August, suggesting that a combination of massive government bond purchases and forward guidance on interest-rate policy could achieve the same stimulus as cutting the overnight rate to minus 6%, were negative interest rates possible. She might be right, but most economists are skeptical that the Fed’s unconventional policy tools are nearly so effective.

There are other ideas that might be tried. For example, the Fed could follow the Bank of Japan’s recent move to target the ten-year interest rate instead of the very short-term one it usually focuses on. The idea is that even if very short-term interest rates are zero, longer-term rates are still positive. The rate on ten-year US Treasury bonds was about 1.8% at the end of October.

That approach might work for a while. But there is also a significant risk that it might eventually blow up, just the way pegged exchange rates tend to work for a while and then cause a catastrophe. If the Fed could be highly credible in its plan to hold down the ten-year interest rate, it could probably get away without having to intervene too much in markets, whose participants would normally be too scared to fight the world’s most powerful central bank.