Even while the economy and markets are booming, Federal Reserve officials are worrying about how they'll respond to the next recession, and they don't especially like the picture they see.
It's one where the economy starts contracting but the Fed, still at a low interest rate, has little ability to respond. It lowers rates to zero but that amounts to only a fraction of the stimulus it has provided in past downturns. Once again, the Fed faces the quandary of what more it can do when it's at zero and can't cut anymore and is forced to contemplate extraordinary, uncertain and controversial measures like quantitative easing.
More and more, Fed officials and academic economists are wondering if there's a better way and beginning to think seriously about a dramatic change to monetary policy that would revise or even scrap its current, flailing 2 percent inflation target.
The Fed has missed that target almost since it was implemented in 2012, undermining its credibility in markets and possibly entrenching expectations that inflation will always run below target.
Former Treasury Secretary Larry Summers, speaking at a Brookings Institution conference this week on the Fed's inflation target problem, urged the Fed to get moving on a fix. He noted that the Fed typically has lowered interest rates by 5 percentage points over time to stimulate the economy in recessions. The Fed doesn't have 5 points now, so the next recession will find the central bank less able to kick-start growth, possibly enabling a longer, deeper downturn.
Source: Larry Summers
"The overwhelming likelihood is that when recession comes, policy will not have sufficient room to cut rates as much as it would like to within the current framework,'' Summers said.
Quoting a recent research paper, Summers suggested the Fed could be at a zero interest rate 30 to 40 percent of the time in the future unless it changes its current regime. "I am completely unconvinced that (quantitative easing) can be our salvation next time around,'' Summers said.