When the next recession strikes, what options will central banks have?
“As the last few monetary-policy cycles have shown, even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively,” according to Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates. “Interest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy.”
And when that happens, Roubini says the Federal Reserve and other major central banks will be left with just four options, each with its own costs and benefits.
In a column on Project Syndicate, Roubini weighs these four options and what he calls the “new abnormal in monetary policy.”
“When the next recession strikes, central banks in advanced economies will have no choice but to plumb the zero lower bound once again while they choose among four unappealing options,” Roubini writes. “The choices they make will depend on how they weigh the risks of bloating their balance sheets, imposing costs on banks and consumers, pursuing possibly unattainable inflation targets, and hurting debtors and producers at home.”
Here are the four options central banks will have in the next recession, according to Roubini.
1. Central banks could restore quantitative- or credit-easing policies, by purchasing long-term government bonds or private assets to increase liquidity and encourage lending.
“But by vastly expanding central banks’ balance sheets, QE is hardly costless or risk-free,” Roubini says.
2. Central banks could return to negative policy rates — as the European Central Bank, Bank Of Japan, Swiss National Bank and some other central banks have done — in addition to quantitative and credit easing, in recent years.
“But negative interest rates impose costs on savers and banks, which are then passed on to customers,” writes Roubini.
3. Central banks could change their target rate of inflation from 2% to, say, 4%, Roubini says. “The Fed and other central banks are informally exploring this option now, because it could increase the equilibrium interest rate to 5-6%, and reduce the risk of hitting the zero lower bound in another recession,” he writes.
However, this option is controversial because central banks are already struggling to achieve a 2% inflation rate. To reach a target of 4% inflation, they might have to implement even more unconventional monetary policies over an even longer period of time, according to Roubini.
“Central banks should not assume that revising inflation expectations from 2% to 4% would go smoothly,” he writes. “When inflation was allowed to drift from 2% to 4% in the 1970s, inflation expectations became unanchored altogether, and price growth far exceeded 4%.”
4. The last option for central banks is to lower the inflation target from 2% to, say, zero percent, as the Bank for International Settlements has advised, according to Roubini.
“A lower inflation target would alleviate the need for unconventional policies when rates are close to zero percent and inflation is still below 2%,” Roubini says.
But Roubini says most central banks have their reasons for not pursuing such a strategy.
“Zero inflation and persistent periods of deflation — when the target is 0% and inflation is below target — may lead to debt deflation,” he writes.
He adds that this could lead to more debtors falling into bankruptcy.
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