Fed has little room to maneuver rates
Going negative is too much risk of deflation or sharp inflation
For most of the last 30 years, U.S. inflation has resided in a kind of sweet spot for investors and the economy — low enough to keep interest rates down and asset prices up, but not so low as to risk ruinous deflation.
That remarkable period of stability seems set to end. Among the many consequences of the coronavirus recession is its likely impact on consumer prices, first down and then up.
Since the Great Recession ended in 2009, policymakers at the Federal Reserve have worried that inflation would be too low when the next recession struck, a risk akin to an airplane encountering turbulence while barely airborne.
Those fears have been realized. With interest rates already at low levels when the recession began, the Fed has little room to maneuver rates lower without taking them into negative territory, a place where policymakers prefer not to go.
Potentially, too low inflation could trigger structural deflation — chronically falling prices across much of the U.S. economy — in the same self-perpetuating spiral that has kept Japan in a perpetual state of slow growth and intermittent recession since the early 1990s.
Over the near term, the economic effects of the COVID-19 pandemic in the U.S. will be strongly deflationary. Headline inflation could soon drop below zero given weak energy prices and fewer places for consumers to spend. But even core inflation, which excludes food and energy, could turn negative, at least until the economy begins to bounce off the bottom this summer.
What if rates go negative?
The Fed has a stated goal for inflation of 2%, as measured by its preferred metric, the core personal consumption expenditures index. That index peaked at 10% in the mid-1970s and the early 1980s, before starting a long and gradual decline, a healthy process known as disinflation.
Core PCE has failed to meet the Fed’s 2% target in all but 14 of the 138 months since the peak of the financial crisis in late 2008, despite unusually low interest rates.
Though Fed chair Jerome Powell insists that the central bank has plenty of monetary ammunition remaining, even after using $2.3 trillion in an initial round of emergency lending, the possibility exists that benchmark rates eventually will drop below zero, as they already have in Europe and Japan.
Negative interest rates are what they seem: depositors effectively pay financial institutions to hold their money, a penalty intended to induce savers to spend, businesses to borrow, and banks to lend.
But deflation isn’t the only risk. Paradoxically, there are also concerns of an abrupt rise in inflation, perhaps even to 1970s levels, when consumers feel safe enough to resume their normal lives. In the context of what is likely to remain a sluggish economy for years to come, expectations for slow growth and high inflation — dubbed stagflation in earlier times — could become a self-reinforcing prophecy. Near term, deflation is the far greater risk. Unambiguous Fed backing for government and corporate bonds should keep the fixed-income market a relatively stable, if not particularly lucrative, place to park funds.
Perhaps as early as mid-2021, however, consumer prices could spike as trillions of government created and dispensed dollars chase a pool of goods and services shrunken by bankruptcies, broken supply chains and idled factories. Though central banks have grown their balance sheets by trillions of dollars over the last decade without an inflationary effect, that earlier digital money was easily absorbed by a global savings glut and underfunded pension funds.
Governments also will be incentivized to inflate their way out of debt, as did Germany after World War I and the U.S. after World War II. America alone could add at least $3 trillion to a national debt that already was slightly above 100% of GDP even before the pandemic recession.
The economic historian Robert Skidelsky recently cautioned that the world economy could suffer an “inflationary depression” as rising consumer prices interact with high unemployment.
For three decades, low and stable goods and services inflation underwrote asset inflation by removing the threat of tighter monetary policy, and by making cash unattractive.
In one way or another, that Golden Age of consumer price stability seems likely to end, yet another casualty of the worst public health crisis in 100 years.
Since the Great Recession ended in 2009, policymakers at the Federal Reserve have worried inflation would be too low when the next recession struck, a risk akin to an airplane encountering turbulence while barely airborne. Those fears have been realized.