The Fed should buy recession insurance…

Brad DeLong in this article says Fed should buy recession insurance:

…if the next downturn is looming, North Atlantic central banks do not have the policy room to fight it effectively. Should a recession arrive, the US Federal Reserve would ideally be able to cut interest rates by five percentage points, as is customary in such situations. But with short-term safe interest rates currently at 2.4%, it cannot. And with euro and yen interest rates still around zero, the European Central Bank and the Bank of Japan would be unable to help much, either. 

Looking ahead, therefore, the big risk is not that inflation will start spiraling upward, with the Fed unable to raise interest rates fast enough to stabilize the economy. Rather, it is the downside risk that a year from now, the North Atlantic will be in recession, governments will not provide enough fiscal stimulus, and the Fed won’t be able to reduce interest rates enough – leaving it nearly helpless to even try to stabilize the economy.

The logical response to such an asymmetric risk is – or ought to be – to buy insurance to cover it. Worryingly, however, the Fed is not taking out any policy insurance at all against a possible recession, despite having at least three possible options from which to choose.

Three options are: raise policy rates today, cut interest rates today to try to compensate for its inability to reduce rates enough in a future downturn and leave interest rates unchanged for now. It is doing the third option but is not explaining what happens if a recession occurs.

A more credible Fed plan to fight a possible recession in 2020, 2021, or thereafter might well boost business confidence and make the central bank’s policies more effective. At the very least, it would reassure companies and investors who, fearing that US aggregate demand will be weak in 2020, might be starting to pull back. But this third option would require an aggressive intellectual and communications effort from the Fed, and there is currently no evidence of one.

If the US falls into recession over the next year or two, the Fed may have very little room to loosen policy. And yet it is not taking any steps to cover that risk. That is unwise. Unless the Fed buys some recession insurance soon, the US – and the world – may well face much bigger problems later.

Phew…

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