When the next recession unfolds, central banks will be unable to reverse a downturn, says former United States Treasury Secretary Larry Summers. In other words, the global central banks are out of bullets.
Speaking in an interview with CNBC, Summers explained that central banks slash interest rates by around 500 basis points in order to prevent a recession from growing. However, with rates as low as they are today – in nearly a dozen countries there are subzero interest rates – there isn’t any more room for central banks to decrease rates.
“Probably sometime in the foreseeable future we’ll have a recession in some major part of the world. And yet we don’t really have the fuel in the tank to respond,” said Summers. “That’s got to be a matter of serious concern … in terms of monetary policy frameworks, a matter of serious concern requiring more use of fiscal policies than we’ve seen so far.”
This isn’t the first time that something like this has been said.
In June, Federal Reserve Chair Janet Yellen told Congress that when the next recession happens the Fed can’t do anything (SEE: Janet Yellen admits Federal Reserve can’t do anything when next recession strikes).
“If there were to be a negative shock to the economy…we don’t have a lot of room using our traditional tried and true methods to respond,” Yellen said in her semi-annual testimony to Congress.
According to Yellen, the U.S. central bank only has a couple of options: introduce negative interest rates, launch a fourth round of quantitative easing or move ahead with helicopter money.
In August, a Fed paper found that the central bank would need an additional $4 trillion or $5 trillion to combat another recession because it has already employed all of the conventional monetary policy tools available (SEE: Federal Reserve paper reveals another $4 trillion needed to fight off recession).
“In the simulations. QE and forward guidance take 10yr yields down 225-300 bps depending on the starting point for fed funds and whether you do $2 trillion or $4 trillion for QE. But that is not going to work very well if by design fed funds and 10yr yields can’t go below zero. And if expected rates are already low then forward guidance does not have much room. Fed official will gave to keep a straight face while saying they we will keep rates at zero … forever.
“What makes it work is that QE and committing to low rates for longer gets the long rate down quickly and this compensates for the inability to take short rates down as far as you would want. In the unconstrained model, the maximum drop in short rates is almost 9 percentage points, almost twice as much as in the constrained model, but the QE/forward guidance lower takes (and keeps) long rates 75bps lower than when the Fed takes rates to zero and stops. When the Fed is starting from 3% fed funds, the combo can almost entirely offset the zero constraint, but only if the full $4 trillion QE is brought to bear. Starting from 2%, QE of $2 trillion is not enough to get long rates down far or fast enough to offset the shock.”
It looks like the leaders of the world will have another interesting decade to come.
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