If the Federal Reserve Board has used all of its policy tools during the current expansion, what happens when there’s a recession?
That’s a question worth asking, even as the Fed appears ready to raise interest rates, albeit by just a smidgen, based on the pretext that ZIRP (zero interest rate policy) is no longer needed, given today’s allegedly booming economy.
On course, the economy’s not booming and we may even be heading into a recession, assuming we aren’t already in one (it’s hard to tell in today’s slow growth-no growth economy). 
Just one sign that the boom is an illusion is the length of the current expansion. The average recovery since the end of World War II has been 58 to 61 months, depending on whose numbers you use. The current “recovery” hit the 58-month milestone in April 2014 – 20 months ago. As David Stockman pointed out this week in his “Contra Corner” blog, “the only expansion that was appreciably longer than the present tepid affair was the 119 month stretch of the 1990s.”
Nothing lasts forever and even Larry Summers, the former Treasury secretary and current Harvard professor, recognizes that the current expansion may be nearing an end. As he wrote last week in a Washington Post op-ed, “U.S. and international experience suggests that once a recovery is mature, the odds that it will end within two years are about half and that it will end in less than three years are over two-thirds. Because normal growth is now below 2 percent rather than near 3 percent, as has been the case historically, the risk may even be greater now.”
Just because the current expansion has felt like a recession, it doesn’t mean we’ll have a recession that feels like an expansion. Given current economic conditions worldwide, a recession anytime soon could be nasty. The woes of China, Japan, Europe, et al. have been documented here in the past. All of the world’s central bankers are not making them any better.
Nothing in the Tool Box
It’s in this context that the Fed appears ready to raise interest rates. Symbolic though a 25-basis-point increase would be, it will have real consequences, likely rattling both the stock and bond markets, which the Fed so successfully juiced with its quantitative easing. Mortgage rates will rise more than 25 basis points and American goods, which already reflect the cost of paying the world’s highest corporate tax rate, will become less competitive.
So be it if the economy really is strengthening, but what will the Fed’s prescription be if a recession comes?
The monetary response to a recession, according to Summers, who is a Keynesian, should be to “cut interest rates by more than 300 basis points.”
Unfortunately, though, since the current federal funds rate is already zero, lowering it by another 3% is not an option. While the current recovery is among the longest on record, zero interest rate policy (ZIRP) has been in effect the entire time.
The current recovery has lasted 78 months. ZIRP has lasted an astounding 84 months.
“Yet during that same period,” Stockman wrote, “the consumer price level has risen by 1.75% per year. And that’s if you give credit to all of the BLS gimmicks, such as hedonic adjustments for quality change, homeowners ‘imputed’ rents and product basket substitution, which cause inflation to be systematically understated.
“On a basis that is close enough for government work, therefore, the real money market interest rate has been negative 2% for seven years. But that’s so crazy, unjustified, and unprecedented that even the Keynesian money printers who run the Fed have run out of excuses.”
When you shoot off all of your fireworks on July 3, the next day is going to be a challenge. That’s the situation the Fed faces today.
Or, as Stockman put it, “If you wait until month 78 of a business expansion to end the emergency policy, and then hesitate to venture more than a few basis points off the zero bound, you will indeed use up the remaining runway right quick.”
We’ve previously speculated about the possibility of another round of bond buying by the Fed, but it’s unlikely that a fourth round of quantitative easing would be effective. God knows, the first three rounds had little impact, except to boost the Fed’s portfolio from $300 billion pre-financial crisis to $4.5 trillion today. The economy has not grown as fast as the Fed portfolio, to put it mildly.
“The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable,” according to Stockman. “There are severe limits on how negative rates can become.”
So the Fed is at the Alamo without any ammunition. This is what happens when you cede control over the economy to central bankers.