When the Federal Reserve lowered interest rates to almost zero after the financial crisis it appeared to halt the economic slide and sparked a fairly anemic recovery that’s been hobbling along ever since. Despite that weakness equity markets are surging. We must remember, however, that the stock market is not the economy.
The new normal
Now that the Fed is starting to raise rates it is tempting to believe we are out of the woods. The hope is that inflation and interest rates combined will get back to pre-recession levels of around 6%. A recent Brookings study says otherwise, stating that near zero interest rates and modest inflation below the Fed’s target of 2% may be the new normal. This indicates the U.S. economy has, in essence, changed in a way that prevents current monetary policy from having any tools to reverse the next downturn. Without interest rates to lower what’s left for the Fed if the economy goes back into recession?
Outside the monetary box
One idea suggested in a recent New York Times article by Justin Wolfers, a professor of economics and public policy at the University of Michigan, is to look for answers outside of the Fed when the economy goes south. The concept is to focus on taxation and things like infrastructure spending when the economy is struggling and the Fed’s hands are tied. These “automatic stabilizers” could be implemented without getting Congress involved. This shift to a more proactive fiscal policy may be the only choice in this new low interest rate, low inflation rate environment.