How Congress Can Help the Fed Fight Recessions
The Federal Reserve is grappling with a difficult question: If interest rates remain low, leaving the central bank with less leeway to ease monetary policy, will it have sufficient ammunition to fight the next economic downturn?
The Fed could use some help from Congress.
Over the past 50 years, the Fed’s short-term interest rate target has always peaked above 5 percent during economic expansions. As a result, when the economy has turned south, the central bank has been able to cut interest rates aggressively.
The current expansion looks different. The futures market anticipates that the target fed funds rate has already peaked at less than 2.5 percent. If this proves broadly correct, then the Fed will have much less room to cut rates than it has had in the past.
The limited firepower has prompted Fed officials to examine their options- for example, by considering whether to change the central bank’s inflation mandate. Some have suggested increasing the inflation target to 4 percent, from the current 2 percent. This would, in turn, raise the peak in short-term rates by 2 percentage points. Voila! The Fed would have more ammunition.
But a higher inflation target would entail significant costs. First, 4 percent inflation would be very hard to reconcile with the Fed’s congressional mandate to keep prices stable. Second, the Fed has worked very hard, at great cost, to anchor people’s inflation expectations at 2 percent -- an achievement that changing the target would discard, making it harder to re-anchor expectations in the future. After all, if the Fed changed the target once, why should people believe it won’t change again?
There’s a simpler solution: Use the power of the government budget. Specifically, Congress should create a fiscal stimulus trigger that would automatically cut taxes and boost spending when the economy entered a slump. For example, whenever the unemployment rate climbed above some threshold -- say 6 percent -- unemployment benefits could be extended and payroll income taxes cut.
Such a trigger would have some big advantages. Help would arrive more rapidly and with greater certainty, providing much-needed reassurance and reducing the risk of a deep recession. As a result, households and businesses would likely feel less need to tighten their belts aggressively, making downturns less severe. In other words, the mere prospect of greater fiscal stimulus would make the economy more stable.
The U.S. economy already has automatic stabilizers. Spending on safety-net programs rises during downturns, and taxes fall as people and companies make less money. I’m just proposing to make these stabilizers more powerful, and to communicate the change to households and businesses, so they know ahead of time that the support will come.
Put simply, the Fed shouldn’t always go it alone. It’s good to recognize that the central bank’s powers aren’t unlimited, and that it might need a helping hand. This is especially true when the Fed is likely to have less scope for cutting rates.
So will Congress act? There’s a growing consensus that fiscal stimulus is appropriate during economic downturns, even when budget deficits are high. Interest rates tend to be lower during slumps, which holds down debt service costs. And added fiscal support makes the economy stronger than it otherwise would be, mitigating damage and bolstering tax revenue.
That said, Congress may be reluctant to relinquish a measure of control over fiscal policy. It’s fun to hand out tax cuts and government largesse -- and this can be lucrative in terms of gathering campaign contributions. Legislators must recognize, though, that the U.S. economy would be much better off with greater certainty that help would arrive in a timely way and not just from the Fed.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.