Around the world, markets are in chaos. Japan's stock market plunged 5 percent on Friday, while markets in France, Germany, and the UK all saw big losses on Thursday. The US stock market is doing better than most, but it is also down since the start of the year. Oil hit a new low on Thursday of $26 per barrel.
These declines reflect growing concerns that the world economy is headed for another recession. Before 2007 we’d say, "If things get bad, the Fed will cut interest rates." But with the Fed’s benchmark rate below 0.5 percent already, a substantial cut would mean rates that are below zero. That's an unorthodox strategy, and it might not even be legal, according to testimony by Fed Chair Janet Yellen before congressional committees this week.
The Fed needs a new strategy: Stop targeting interest rates and instead target the growth of the overall economy. Moving away from interest rate targeting would give markets confidence that the Fed has the tools to deal with the next economic downturn, which would reduce the danger of another 2008-style meltdown.
Unfortunately, there's little sign that the Fed is laying the groundwork for a shift in strategy. Instead, Yellen seemed to be in denial about the magnitude of the challenge she is facing.
"Let’s remember that the labor market is continuing to perform well," she said to the Senate Banking Committee on Thursday. "We want to be careful not to jump to a conclusion about what is in store for the economy." Maybe not — but the Fed needs to be prepared for the worst.
The Fed needs a new game plan for the next recession
"The Fed needs to change their fundamental approach," argues Scott Sumner, a monetary policy expert at the Mercatus Center. Right now the Fed's policy discussions are all about where to set short-term interest rates. But not only does that approach stop working when interest rates fall to zero — as they did in 2008 — but interest rates aren't even what people actually care about.
Instead, Sumner argues, the Fed should start directly targeting a variable people do care about: either the inflation rate or (even better) the total amount of spending in the economy. He argues that the Fed should focus on setting long-run goals for these variables and then doing whatever it takes to meet those goals.
The Fed currently has an official target of 2 percent inflation. But the central bank's actions make it clear that it's not serious about this target. Last December, for example, the Fed's own forecast showed that inflation would be around 1.6 percent in 2016 — and the forecast inflation rate had actually been falling. Yet the Fed raised interest rates anyway. That was a pretty clear signal to the markets that the Fed cared more about returning to "normal" interest rates than it did about achieving its inflation target.
The problem isn't just that the economy will grow a little bit slower in early 2016 than it could have otherwise. By ignoring its own targets, the Fed sent a message that it wasn't really committed to robust growth over the long run, which undermines businesses' confidence in the recovery and discourages investment.
The solution, Sumner argues, is for the Fed to use a strategy called level targeting to make its own targets more credible. Under a level targeting regime, the Fed would compensate for missing its target in one year by overshooting the following year. For example, in 2015, the Fed's preferred measure of inflation came in at 1.4 percent — 0.6 percent below the Fed's 2 percent target. Under level targeting, the Fed would aim to achieve 2.6 percent inflation in 2016, delivering 2 percent inflation on average in 2015 to 2016. That would not only support faster economic growth in 2016, it would also give the markets more confidence in the Fed's forecasts for 2017, 2018, and beyond.
Abandoning interest rate targets allowed the Fed to beat inflation
Abandoning interest rate targeting might seem radical, but the Fed has actually done it once before, in the late 1970s. Back then, it seemed that no matter how high the Fed raised interest rates, it couldn't get inflation under control. So in 1979, the Fed stopped targeting interest rates altogether.
Instead, it simply set a target for the total amount of money in the economy. Fed Chair Paul Volcker knew that if the amount of money in circulation stopped rising, the inflation rate would eventually have to stop rising too. It took a couple of years (and helped induce a major recession in 1980), but it worked.
A big reason the strategy worked is that markets believed Volcker was serious about the target. Targeting the money supply directly signaled he was willing to let interest rates go as high as they had to in order to get inflation under control. Once markets believed he was serious, they started doing a lot of his work for him — and businesses began to curtail price increases in the expectation that the overall inflation rate was going to decline.
Today we're facing the reverse situation. A big reason the economy has been recovering so slowly is that businesses are worried about sluggish growth — or, worse, another 2008-style meltdown — in the coming years. So they've been reluctant to invest, making slow growth a self-fulfilling prophecy.
If the Fed can convince businesses that it's serious about delivering consistent growth, businesses will start investing more in the expectation that demand for their products will grow — and that investment will itself produce growth.
Level targeting is a strategy for giving the market more confidence in the Fed's long-term targets. And while inflation-based level targeting would work better than what we're doing now, Sumner argues that the best strategy would be to target the total amount of spending in the economy. This approach, known as nominal GDP targeting, has been endorsed by prominent economists such as Christina Romer.
The Fed's favorite tool for fighting recessions is broken
There are two big problems with the Fed's current strategy of focusing on interest rates. The obvious one is that once rates hit zero, the conventional approach to monetary policy becomes ineffective. After rates hit zero in 2008, the Fed was forced to use an ad hoc strategy known as "quantitative easing" to pump more money into the economy. Lacking experience with this new strategy, the Fed twice made the mistake of ending easing too early, slowing the economic recovery between 2010 and 2012.
The larger problem with zero interest rates, however, is politics. People are used to thinking of low interest rates as a sign of easy money and vice versa, so the zero interest rate struck many as a sign of recklessly easy monetary policy. In the years after the financial crisis, critics warned that Fed policies would create runaway inflation.
In retrospect, it's clear that these concerns were unfounded. The average inflation rate since 2008 has been well below the Fed's 2 percent target, while the economy has suffered from persistently slow job and wage growth. But fear of a political backlash for doing "too much" discouraged Yellen's predecessor, Ben Bernanke, from acting decisively to promote economic growth.
More recently, the Fed has come under a lot of pressure to "normalize" — that is, raise — rates above zero percent. After resisting these pressures for most of 2015, the central bank finally pulled the trigger in December, boosting its target rate from zero percent to 0.25 percent. It did this despite the fact that — as Vox's Matt Yglesias pointed out at the time — most economic indicators suggested that a rate hike would do more harm than good.
This is the flip side of the situation the Fed faced in the 1970s. Because interest rates were high, many people thought monetary policy was too tight, and the Fed faced a lot of pressure to cut rates. But cutting rates triggered another wave of inflation, forcing the Fed to raise rates once again. Interest rate targets had become a distraction, and abandoning them helped Volcker focus on the variable he really cared about: inflation.
Negative interest rates are a distraction
Negative interest rates are one way the Fed could try to salvage the current regime of focusing on interest rates. But it's not a very good one.
Just as you might have a savings account with your bank, so a nation's banks all have accounts with their nation's central bank. The money deposited in these accounts is called reserves, and in recent years a lot of banks around the world have chosen to build up huge reserve war chests. That's frustrating to central bankers who have been trying to encourage banks to stimulate economic activity by lending out the money.
So recently Japan's central bank and some central banks in Europe have been experimenting with negative interest rates on reserves. Last month, the Japanese central bank announced that banks would be assessed a 0.1 percent penalty on their reserves — an interest rate of -0.1 percent. A bank with a billion yen deposited with the Bank of Japan will now have to pay 1 million yen per year for the privilege.
Obviously, 0.1 percent is not a very big number, so the direct effects of Japan's new policy won't be very large. But going negative breaks through an important psychological barrier — once a central bank has instituted a slightly negative interest rate, it's more likely to cut rates further in the future.
In her testimony before Congress this week, Yellen was pressed on whether the Fed would follow its European and Japanese counterparts and impose a penalty on reserves. Yellen demurred, saying that the Fed's experts were still studying whether negative interest rates would be legal and technically feasible.
But even if the Fed ultimately decides to adopt negative rates, there are real limits on how far they can go. If negative interest rates get too steep, banks have an obvious alternative: They can get physical cash and store it in a big warehouse. By definition, cash is worth as many dollars a year from now as it is today.
There are a couple of ways central banks could try to make negative interest rates more feasible. University of Michigan economist Miles Kimball, for example, advocates a shift to a new form of electronic money that would allow central banks to impose economy-wide negative interest rates. Others argue that the Fed should raise its inflation target so that real, inflation-adjusted interest rates can go lower. But not only do both of these approaches have technical challenges, they're also likely to be intensely unpopular with voters.
So even if the Fed adopted negative rates, it wouldn't improve the effectiveness of the current interest rate targeting regime very much. Just as the Fed got stuck at zero percent interest rates in 2008, it could get stuck at -1 percent interest rates in 2017 or 2018. So the Fed is going to need a new framework that's less dependent on interest rates regardless. It might as well get started.