The Fed’s dual mandate from Congress since 1977 obliges the Fed to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” This focus on unemployment and inflation has largely manifested itself in counter-cyclical monetary policy as the Fed has used policy to respond to strengthening or weakening data in those spheres.
However, if this Fed has shifted to a policy of extending expansions rather than combating recessions, this would appear to signify a meaningful shift in strategy from a de facto counter-cyclical policy to a pro-cyclical policy. The challenge of pro-cyclical policy is then in pondering Fed actions in the event a recession were to occur and counter-cyclical policy were needed.
While the Fed’s actions are felt instantly in the financial markets, there is a delay between when the Fed acts and when the impact is experienced by the real economy. This delay risks the possibility that the real economy deteriorates after a cut, economic data (which itself can lag the real economy) suggests additional rate cuts. In that case, markets and politicians would likely clamour for additional monetary stimulus, but the Fed would be left to encourage patience for its stimulus to kick in and left with a diminished toolkit to respond.
In this way, the risk of a policy shift goes beyond just the proximate downturn and to the core of the Fed’s efficacy. In large part, a central bank’s ability to effect outcomes is driven by moral suasion. Notably, European Central Bank (ECB) president Mario Draghi’s statement that the ECB “is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” was more effective in ending a crisis than any monetary policy tool the ECB has deployed since. If the Fed’s gambit of preemption were perceived to fail, even if only because of the delay between action and flow-through, would they be putting a century of acquired institutional credibility at risk?
To illustrate this point, if the Fed were to cut rates three times this year in line with Fed Fund Futures expectations, but the economy were still to fall into recession in 2020 (acknowledging that any rate cut has a lagged beneficial effect on the economy) the Fed would be facing a recessionary environment but a Fed Funds rate that is 75 bps lower than when they began to cut i.e. a range of 1.50 — 1.75%. If the Fed were to believe further stimulus were warranted, there is then a relatively high probability we would again witness a zero lower bound on Fed Funds rate, despite a high likelihood that any recession is likely to be far more mild than 2008.