Despite all the prosperity Mr. Powell lauded today and described also in recent FOMC minutes in glowing terms, there’s a little-noticed, but critical reality lurking behind all the central-bank happy talk: the U.S. central bank has no clue what it would do if something unexpected overturned all its sanguine expectations. It turns out not only that $4.5 trillion on the Fed’s books and negative real rates didn’t get us anything better than one of the slowest recoveries ever along with unprecedented economic inequality. Quantitative easing and ultra-accommodative policy hasn’t even been a successful learning experience.
That’s not just me talking. After reviewing an equivocal staff model on the impact of the effective lower bound (ELB) and its policy tools, the FOMC said:
…participants acknowledged that there may be limits to the effectiveness of these tools [i.e., all of those the Fed now has] in addressing an ELB episode. They also emphasized that there was considerable uncertainty about the economic effects of these tools. Consistent with that view, a few participants noted that economic researchers had not yet reached a consensus about the effectiveness of unconventional policies. A number of participants indicated that there might be significant costs associated with the use of unconventional policies, and that these costs might limit, in particular, the extent to which the Committee should engage in large-scale asset purchases.
…it was difficult to anticipate the forces that might push the economy into a recession, and thus preserving some flexibility in responding to an economic downturn could be appropriate. Moreover, although making multiyear commitments regarding asset purchases or the future path of the federal funds rate could enhance the effectiveness of these policies, such commitments could unduly constrain the choices of the Committee in the future.
What to do about all these worries?
While the Committee’s current toolkit was judged to be effective, participants agreed, as a matter of prudent planning, to discuss their policy options further and to broaden the discussion to include the evaluation of potential alternative policy strategies for addressing the ELB. Building on their discussions at previous meetings, participants suggested that a number of possible alternatives might be worth consideration and agreed to return to this topic at future meetings. Several participants indicated that it would be desirable to hold periodic and systematic reviews in which the Committee assessed the strengths and weaknesses of its current monetary policy framework.
In short, a seminar series. Larry Summers and other Fed critics (myself included) have long argued that the huge scale of post-crisis monetary policy and the looming presence of the ELB gives the Fed scant ammunition with which to counter unexpected crises or even, in Mr. Summers’ view, a modest turn for the worst.
In his speech, Mr. Powell says that he’s unlikely to be surprised because post-crisis rules have made the financial system more resilient than traditional models assume. So it has, at least for banks, but the way U.S. financial intermediation occurs and the role of regulated banks has changed in concert with all the new rules and not in Mr. Powell’s favor. Further, no model could ever predict what the global reaction to a Presidential tweet might be, especially in these unstable geopolitical times. A Fed without policy tools confronted with unexpected stress is a central bank that had better be right.