The Implications of a 0 Bound Interest Rate Model

It looks as if the US economy is going to be okay...for now. In September, the US economy added 136,000 new jobs, dropping Unemployment to 3.5%, a 50-year low. Our economy continues to thrive despite a slowdown in manufacturing and an ongoing trade war, the US has managed to maintain a level of insulation from the events affecting the global economy, such as the slowdown in the EU and Asia's manufacturing, lower investment in the UK, and the unrest in Hong Kong. Despite this continued domestic economic growth, the Fed has cut interest rates three times this year, which some economists see as troubling. As the Fed keeps lowering rates, some economists think that it is placing itself in a more precarious position for the arrival of the next recession, whenever it occurs. The Fed deciding to cut rates while the economy looks healthy (like it did in September) isn’t necessarily a bad thing. If the Fed thinks there are enough serious threats to growth, such as a trade war, it can cut interest rates slightly as a precautionary measure to keep the economy on an even keel. What is worrisome to some is how little ammunition the Fed has left to fight a potential recession, and some see that it may be dangerously close to “spiraling” rates towards 0 in response to threats that are more and more remote.

The Fed has a very limited toolbox when it comes to how they are able to handle a recession. The primary, and most direct, of these tools, is lowering its benchmark Federal Funds Rate. By lowering interest rates, the Fed would hope to deter long term investments and spur current spending, thus adding money and energy into the economy to maintain growth. Historically in times of growth, the Fed has had a healthy amount of wiggle room when it comes to lowering rates to combat a recession: Since 1987 in times of expansion, the Fed’s benchmark interest rates have peaked at 9.75%, 6.5%, and 5.25% (in 1988, 2000, and 2006, respectively (Amadeo n.d.)). Currently, since the end of the financial crisis of 2008, interest rates have peaked at 2.5%, and the Fed’s overnight loan rate is currently situated at 1.75%, after two cuts in June and September of this year. This is a historically low rate for a period of expansion that has been uninterrupted since June 2009 (Amadeo n.d.).

Having a low interest rate during a period of expansion isn’t necessarily bad in itself, but the consequences if a recession begins can be very pronounced. With a limited ability to stimulate spending with lower interest rates, the Fed could only buffer consumers slightly in the event of an economic contraction. Since 1974, the average rate cut during a recession has been approximately 5 percentage points from the pre-recession levels, with the smallest such response a 2% reduction during the recession of 2001 (Amadeo n.d.). If we were to enter a recession now, a similar reduction would result in either a negative or 0% interest rate.

Many economists see this as a suboptimal outcome and believe that this would greatly decrease welfare in the US. The Wall Street Journal’s Justin Lahart argues the Fed is suffering from a “tail chasing problem”. He says that because interest rates are already so low, the Fed is being forced to make cuts in response to threats that are less and less likely. If the Federal Funds Rate was at 5%, and there was a remote chance of something negatively affecting the economy, the Fed might be more comfortable waiting to act as opposed to acting preemptively as a precautionary measure. But since rates are already so low, the Fed is less likely to sit back and see if this possibility would spark a recession, because they know their tools are limited—leading them to lower interest rates to protect against a low probability outcome. As rates get lower and lower, the Fed would then have to keep lowering rates to more and more remote threats, pushing their rates down even before a recession.

Powell has been quoted as saying “an ounce of prevention is worth a pound of cure” meaning that he himself is of the belief that preventative measures are better than reactionary measures: hence the way that his Federal Reserve has functioned—and there is actually some interesting research to back up his claim. In their 2006 article, Adam Klaus and Roberto M. Billi talk discuss the viability of a 0-bound interest rate, and what such a bound would look like in relationship to the widely accepted New Keynesian Model of economics. Under this model, the economy would assume a real interest rate of 0 as the lowest interest rate possible, or the lower bound. As they ran a model with the 0 lower bound interest rate in place, they tried to predict what the optimal monetary policy would be in a number of different scenarios. What they found is that a model of this sort “seems neither to impose large constraints on monetary policy to generate any additional welfare losses”. Their conclusion showed that a nominal interest rate of 0 would not negatively affect the economy in ways that some models had previously predicted and did not have any additional negative effects on an economy. In their paper, they show that when a government is committed to a 0 bound nominal interest rate, the Fed would adopt a policy more similar to that of Powell’s Fed—where prevention is prioritized over reactionary monetary policy. Under a system where a 0% interest rate is accepted as the lowest bound of the function, the Fed would be more prone to preemptive rate cuts than in traditional models, and more likely to cut rates in times of expansion than previously contrived models predicted, just like Powell and the current Fed.

With this model in mind, the actions of the Fed seem less ill advised, and more in line with legitimate academic theories of what monetary policy is expected to be. This isn’t to say that there is reason to worry about a potential recession in the near future—with all of the uncertainty of today's globalized economy, having such a low Federal Funds Rate entering a recession would certainly be troublesome. While it may be troublesome to some, the policies of the Fed still seem to line up with that of academic theories and research, easing some of the fears associated with their recent rate cuts.

The policy of cutting interest rates in response to perceived threats, and the idea that “an ounce of prevention” is more valuable than reaction, or “cure” seems to hold up when examined closer, but it does not mean there is nothing to worry about. The economy is cyclical, and eventually this record setting period of expansion will come to an end and we will see another contraction in the US economy. Whether they are correct or not, the Fed’s policies now will certainly impact how the country reacts and handles the inevitable recession—we will just have to wait and see when it happens.

Works Cited

Adam, Klaus, and Roberto M. Billi. 2006. “Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates.” Journal of Money, Credit, and Banking 38 (7): 1877–1905. https://doi.org/10.1353/mcb.2006.0089.

Amadeo, Kimberly. n.d. “Highest and Lowest Interest Rates and Why They Changed.” The Balance. Accessed October 4, 2019. https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135.

Chaney, Sarah. 2019. “U.S. Economy Added 136,000 Jobs in September.” Wall Street Journal, October 4, 2019, sec. Economy. https://www.wsj.com/articles/u-s-september-nonfarm-payrolls-grew-steadily-11570192288.

Lahart, Justin. 2019. “The Fed’s Tail-Chasing Problem.” Wall Street Journal, September 16, 2019, sec. Markets. https://www.wsj.com/articles/the-feds-tail-chasing-problem-11568650891.

Timiraos, Nick. 2019. “Fed Cuts Rate for Third Time This Year, Signals Pause.” Wall Street Journal, October 30, 2019, sec. Economy. https://www.wsj.com/articles/fed-cuts-rates-by-quarter-point-11572458556.

“United States Fed Funds Rate | 2019 | Data | Chart | Calendar | Forecast.” n.d. Accessed October 4, 2019. https://tradingeconomics.com/united-states/interest-rate.