The Fed’s Job Is About to Become Much Harder

The comments above & below is an edited and abridged synopsis of an article by Lawrence H. Summers

There is a 20% chance the US economy will go into recession during the next Fed chair’s term; recovery is in its 9th year, with slow underlying growth, low unemployment and high asset prices.

The Fed has responded to recessions by cutting interest rates, with the benchmark Fed funds rate falling by 400 basis points or more during downturns over the past 2 generations. This time, it is unlikely that there will be room for this kind of rate cutting. To influence longer-term rates, the Fed will have to improvise through a combination of rhetoric and direct market intervention. This will not be easy given that 10-year Treasuries currently yield below 2.20%.

The economy seems brittle within the current inflation-targeting framework. New Fed leadership will have to give serious thought to shifting this framework; not easy given current circumstances. Once a recession comes, it will be too late.

China poses serious risks. The Fed said that even if the stock market lost half its value, the unemployment rate reached 10%, and real estate prices fell as much as they did in the last crisis, all the big institutions would be fine at current capital levels. Market evidence suggests otherwise; based on past patterns, their equity values would collapse.

The most profound challenges will be political. In international matters, the Fed is partnered with an understaffed and amateurish Treasury. The temper of the times has turned against technical expertise in favour of populist passion, and the Fed is the quintessential enduring apolitical institution.