February 23, 2018 / 9:17 PM / 3 months ago

With rates still low, Fed officials fret over next U.S. recession

NEW YORK, Feb 23 (Reuters) - Federal Reserve policymakers fretted on Friday that they could face the next U.S. recession with virtually the same arsenal of policies used in the last downturn and, with interest rates still relatively low, those will not pack the same punch.

In the midst of an unprecedented leadership transition, Fed officials are publicly debating whether to scrap their approach to inflation targeting, how much of its bond portfolio to retain, and how much longer they can raise interest rates in the face of an unexpectedly large boost from tax cuts and government spending.

After years of near-zero rates and $3.5 trillion in bond purchases all meant to stimulate the economy in the wake of the 2007-2009 recession, the Fed has gradually tightened policy since late 2015. Its key rate is now in the range of 1.25 to 1.5 percent, and while the Fed plans to hike three more times this year it has also forecast that it is about halfway to its goal.

That could leave little room to provide stimulus when the world’s largest economy, which is heating up, eventually turns around.

“We would be better off, rather than thinking about what we would do next time when we hit zero, making sure that we don’t get back there. We just don’t want to be there,” Boston Fed President Eric Rosengren told a conference of economists and the majority of his colleagues at the central bank.

Rosengren, one of only a few sitting policymakers who also served during the last downturn, said the expanding U.S. deficits could further erode the government’s ability to help curb any future recession. “With the deficits we are running up, it’s not likely (fiscal policy) will be helpful in the next recession either,” he said.

Since mid-December the Republican-controlled Congress and U.S. President Donald Trump aggressively cut taxes and boosted spending limits, two fiscal moves that are expected to push the annual budget deficit above $1 trillion next year and expand the $20 trillion national debt.

That stimulus, combined with synchronized global growth, signs of U.S. inflation perking up, and unemployment near a 17-year low could set the stage for overheating that ends one of the longest economic expansions ever.

“We want more shock absorbers out there and really ... the main shock absorber is the ability to reduce the fed funds rate, which means that you want to get to a higher inflation rate so that the pre-shock fed funds rate is 4 and not 2,” said Paul Krugman, the Nobel Prize-winning economist and professor at City University of New York.

In a speech to the conference hosted by the University of Chicago Booth School of Business, Krugman said every recession since 1982 has been caused by “private sector over-reach” and not Fed tightening, as in decades past.

The conference’s main research paper argued the central bank should focus on cutting rates in the next recession and avoid relying on asset purchases that are less effective in stimulating investment and growth than previously thought.

In October the Fed began trimming some of its assets and it has yet to decide how far it will go. William Dudley, president of the New York Fed, told the conference that, to be sure, the ability to again purchase bonds if and when rates hit zero “seems like a good tool to have.”

The Fed’s approach to any economic slowdown would likely be to cut rates, pledge further stimulus, and only then buy bonds. Rosengren and others dismissed the possibility of adopting negative interest rates, as some other central banks have done.

Yet five years of below-target inflation, combined with an aging population and slowdown in labor force growth, has sparked a debate over ditching a longstanding 2-percent price target.

Some see this month’s succession of Fed Chair Janet Yellen by Jerome Powell as ideal timing to consider new frameworks that could help drive inflation, and rates, higher. Cleveland Fed President Loretta Mester, who the White House is considering naming Fed Vice Chair, told the conference the central bank could begin to reassess the framework later this year though she added that the threshold for change should be high. (Reporting by Jonathan Spicer Editing by Chizu Nomiyama)

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