Very excited about my latest paper with Chris Collins at PIIE. “Are Central Banks Out of Ammunition to Fight a Recession? Not Quite.” piie.com/publications/p… 1/8
We make 4 key points: First, the US Federal Reserve has room to cut short- and long-term interest rates (thru QE) that is sufficient for a mild recession, but not a severe one. 2/8
Second, the Fed will need to use negative interest rates even for a mild recession. Rates cannot usefully go much below -0.5 percent, but even that is more powerful than it seems because it opens up scope to do more QE and push bond yields below zero. 3/8
Second (cont’d), QE cannot push bond yields below zero if markets believe the central bank will never set its policy rate below zero. 4/8
Third, the ECB (euro area) and Bank of Japan do not have significant room to cut short- and long-term interest rates any further. But they do have other tools that are both powerful and controversial (and which the Fed lacks). 5/8
Fourth, trying to raise inflation expectations once the economy is in recession, either by raising the inflation target or by adopting “make-up” strategies, is not likely to be credible. 6/8
Fourth (cont’d), but, if higher inflation expectations could be achieved before the next recession starts, it would increase central bank ammunition by far more than is commonly assumed. 7/8
Fourth (cont’d), each percentage point increase in long-run inflation expectations increases central bank ammunition by the equivalent of about 2.5 percentage points of room to cut the policy interest rate (because it increases the scope for QE). 8/8
