Brief thoughts about being at the zero lower bound when recession begins
I was looking at Tim Duy’s latest post on monetary policy and asking myself the same question he asks about normalizing the interest rate cycle. Here’s what Tim wrote about getting off the zero bound:
“it is perfectly reasonable to believe that the next recession will hit before we lift off the zero bound. Moreover, it would be relatively uncommon for the peak-to-peak cycle to last more than 90 months. Only 4 of the last 11 cycles have exceeded this length of time.
So I am getting a little nervous that we will not lift off from the zero bound before the next recession hits. Or maybe the attempt to lift the economy off the zero bound is the trigger of that recession. In either case, I am thinking it would be very bad to be still at the zero bound when that recession hits. “
I agree with the sentiments here that it would be very bad if the US economy were still mired at zero when recession hits. I have been talking about the zero rate policy as “permanent zero” for just this reason. The point is that it’s not temporary but rather permanent. I have been calling the US zero interest rate policy “permanent zero” for the last two years because I believe that there is something relatively ‘permanent’ about it in the absence of coordinated fiscal/monetary/mortgage/banking policy. I use the term ‘permanent zero’ to reflect the fact that I think ZIRP is a trap and that it is NOT a good panacea in the absence of a coordinated response.
Just as a reminder, here are three posts on the subject from the past two years:
Basically, low rates steal interest income from savers and fixed-income investors and give it to borrowers. It’s as if the Fed reached into your pocket and stole money from you and gave it to the over-leveraged guy down the street drowning in a mountain of debt. Clearly, that’s what moral hazard is all about (and so I don’t advocate the Fed’s zero interest rate policy).
Here’s the thing though. If more borrowing doesn’t occur, it is a net drag on the economy. Since we know that loans create deposits, which end up increasing reserve balances – not the other way around – low rates are entirely dependent on the demand for credit not on the supply of credit.
If President Obama is socialising mortgage losses ahead of the November election via what are effectively cramdowns at Fannie Mae and Freddie Mac then you are going to see some serious refi activity from underwater borrowers. That’s bullish. And that’s what my weekly post was all about.
More at Credit Writedowns Pro. But remember, households are still over-levered and interest rates cannot be stimulative since they are zero percent. When the next recession hits and the yield curve is still flat as a pancake, bad things are going to happen. That’s why I have to remind you how toxic this policy is.
Permanent zero can work over the medium-term if you get refis but longer-term, the economy is dependent on wage and employment growth and monetary policy doesn’t drive that.
That was from January. Before that I outlined why this permanent zero rate policy is toxic in November 2010 and outlined the effects on savers and banks last August. It seems like people are really starting to catch on to this and it’s important. Now, I don’t deny the stimulative effects of low rates if it is done in a coordinated fashion. Just look at what I said in January. The problem is the misallocation of resources and the other longer-term effects for savers and banks as well as for the psychology of deflation. These problems are most evident in an economic downturn when asset prices are not rising to support stagnant incomes and when bank balance sheets are distressed by souring loans. We are not in that part of the cycle yet. Right now, you can see the Fed creating a misplacing of risk that has led to all sorts of inappropriate loans to businesses. What happens when those loans go bad and the Fed isn’t there to cut rates?