Federal Reserve Chairman Jerome Powell came close to acknowledging that the central bank may not have the firepower to fight the next recession and called on Congress to get ready to help.
The current low level of interest rates “means that it would be important for fiscal policy to support the economy if it weakens,” he told the House Financial Services Committee on Tuesday.
The remark, which came in opening testimony that Powell is due to repeat to a Senate panel on Wednesday, was an unusual appeal by the head of a politically independent institution that is used to combating economic contractions on its own.
But it highlights the difficulties that the Fed and other major central banks face in a world of historically low interest rates and why tax cuts and government spending increases may also be needed to fight future downturns.
“There is very little central banks can do” when both short- and longer-term rates are near zero, said Mark Spindel, a co-author of a book about the Fed’s relations with Congress. “We are much closer to a fiscal-monetary collaboration. They are out of optimal monetary policy tools.”
Speaking in Strasbourg on Tuesday, European Central Bank President Christine Lagarde was more explicit than Powell about the limits to central bank power. “Monetary policy cannot, and should not, be the only game in town,” she told European lawmakers. Admitting he was “straying a bit” from his remit, Bank of England Governorr Mark Carney also backed the U.K. government’s new spending program.
The Fed is engaged in an in-depth review of its policies and practices that is aimed at finding ways to enhance its recession-fighting abilities.
Powell’s comment on Tuesday though suggests he recognizes that there’s just so much the central bank can do in that regard.
After three reductions last year, the Fed’s target for short-term interest rates now stands at 1.5% to 1.75%, less than half the 500 basis points in cuts it has made to fight past downturns.
Powell said that the Fed would resort to tools it used in the last recession if it’s again forced to lower short-term interest rates to zero.
They are quantitative easing — in which the Fed buys Treasury bonds to drive down long-term interest rates — and forward guidance on the future direction of short rates.
The Fed chief though made clear that the central bank would not follow the lead of its counterparts in the euro zone and Japan and push rates below zero. “In the U.S. context, that’s not a tool we’re looking at,” he said.
He also dismissed a suggestion that the central bank consider directly funding the government so it can cut taxes and boost spending in a recession.
“That’s really an untested and not widely supported perspective,” he said.
Some economists though think the Fed might have to go that far if the economy turns bad enough.
In a paper last year, former Fed Vice Chairman Stanley Fischer and ex-Swiss National Bank chief Philipp Hildebrand said “unprecedented policy coordination” may be needed to deal with the next downturn, including central banks explicitly financing bigger government budget deficits.
To make room for future fiscal actions to aid the economy, Powell urged lawmakers on Tuesday to rein in budget deficits now.
“Putting the federal budget on a sustainable path when the economy is strong would help ensure that policy makers have the space to use fiscal policy to assist in stabilizing the economy during a downturn,” he said.
His comment came in the wake of the release on Monday of President Donald Trump’s latest budget plans, which would push the gross federal debt above $30 trillion over the next decade.
Some economists argue fiscal policy isn’t a decent substitute for monetary policy when trying to boost economies in the short-term. Harvard University Professor Kenneth Rogoff wrote recently that government stimulus “inevitably involves messy, hard-fought compromises” that limit its effectiveness.
There are dangers for the Fed in collaborating too closely with elected officials because it could undermine its political independence.
Breaking with recent presidential tradition, Trump has repeatedly attacked the central bank for keeping interest rates too high, including posting a tweet on Tuesday that delivered a dig at Powell for his performance on Capitol Hill.
But the president is not alone in seeking favors from the Fed. At Tuesday’s hearing, Democratic Representative Rashida Tlaib from Michigan repeatedly pressed Powell to explain why the central bank hadn’t helped Detroit avoid bankruptcy as it did during the crisis for major U.S. banks.
In the end, economists said there may be no alternative for the Fed in the next contraction but to accept some form of disciplined fiscal-monetary cooperation.
“They are running low on ammunition,” given that they are unlikely to use negative interest rates, said David Beckworth, a senior research fellow at the Mercator Center at George Mason University. “It does seem like they are going to be in a bind in a next recession.”