The Hindu Business Line

Fed behind the curve

Recession prospects can’t be brushed aside


The Federal Reserve positioned itself to stave off recession by dramatical­ly lowering the expected path of interest rates at the Federal Open Market Committee’s March meeting. While that was a step in the right direction, policymake­rs need to be prepared to follow through and cut rates when the time comes.

But will they? Federal Reserve Bank of New York President John Williams’s insistence that recession risks are not elevated reminds me that there remains plenty of room for the Fed to make a policy error and let the economy slip into recession.

Williams said in Puerto Rico on Friday that he still sees the probabilit­y of a recession this year or next year as being not elevated relative to any year. Such dismissive­ness of the possibilit­y of recession seems terribly cavalier given the circumstan­ces.

The Fed has shifted from forecastin­g rate hikes in December to zero increases for 2019.

Such a sharp reversal of expectatio­ns only happens in an economy decelerati­ng at a pace where a recession can’t be ruled out. This by itself suggests elevated odds of a recession compared with a year ago.

Treasury yields

The inversion of the Treasury yield curve should also be a red flag. Not, however, for Williams, who says there are a lot of reasons to think that it has been a recession predictor for reasons in the past that kind of don’t apply today. In other words, Williams believes this time is different.

In contrast, the economists at the San Francisco Fed, which he headed from 2011 to mid-2019, say the spread between three-month and 10-year Treasury yields is the most reliable recession indicator and conclude that there is no evidence that this time is different.

Williams is not alone in dismissing the rising odds of a recession. St. Louis Fed President James Bullard also believes it’s too early to think about cutting rates, preferring instead to watch the incoming data.

Here’s the problem: If the Fed wants to keep this expansion alive, they need to be prepared to lower rates before the data makes a hard turn south. Yet the data could still delay any cuts until after a recession is evident.

That risk still stands despite the Fed’s dovish turn. Remember that an inverted yield curve inversion is a long leading indicator. That means the data will continue to indicate a growing economy for the time being.

Showing independen­ce?

Moreover, the Fed may delay a rate cut to show its independen­ce in response to pressure from the Trump administra­tion for easier policy. President Donald Trump blamed the prospect of slower growth on the Fed’s rate hikes while Larry Kudlow, director of the National Economic Council, just called for a 50-basispoint rate cut. That last rate increase in December placed the Fed in a bad spot from both an economics and political perspectiv­e.

My generally optimistic outlook hinges on the contention that the Fed wants to kill your recession call. They made big steps in that direction following the December rate boost by shifting to a patient policy stance, signalling that we are mostly likely at the peak of this cycle and that they do not intend for restrictiv­e monetary policy.

That said, a policy error remains on the table and we should be watching for signs that the Fed wants fairly conclusive evidence of economic weakness before cutting rates. By then, though, it may too late to keep the next recession at bay.

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