The Effectiveness of Monetary Policy in the Next Downturn

This was a really thoughtful comment from Ray Dalio in a recent WSJ interview regarding the efficacy of monetary policy in future recessions.  He says:

 “I worry about the effectiveness of monetary policy in the next downturn.” That’s because the first tool the Fed can use to goose the economy is to lower interest rates. But since rates were already very low during the crisis, the Fed decided to employ a second tool: creating money as it purchased Treasury and mortgage bonds through a program known as quantitative easing. But such purchases are less effective than lowering rates, says Mr. Dalio, because while interest rates directly affect nearly everyone as they buy houses and cars and shop with credit cards, the people who own financial assets and who benefit from QE don’t necessarily buy more things as a result. QE works best when not much money is in the system and asset prices are low. With lots of money now in the system and the prices of financial assets having soared since the depths of the crisis, such policies will likely be less effective.

“There will have to be a monetary policy number three,” says Mr. Dalio. “This is an issue I haven’t yet figured out.” He adds that “every cyclical peak and trough in interest rates was lower than the one before it since 1980.” One therefore wonders what firepower the Fed will have if it is again called upon to prop up the economy.

This is something I’ve touched on a number of times in recent years.  I wouldn’t be surprised if the Fed is still at 0% on the Fed Funds when the next recession occurs.  And we’ve seen how QE, as currently implemented, appears to have some diminishing returns.  That makes sense since the portfolio rebalancing effect is most powerful when assets are low and potentially very mispriced.  This is why QE1 was very powerful.

But Dalio asks the most important question.  If we’ve already lowered interest rates and asset prices are high (and potentially mispriced on the upside) then what’s the monetary transmission mechanism for Fed policy?   It could probably come in a number of different ways:

• We could implement NGDP targeting.
• We could target exchange rates.
• The Fed could buy alternative assets directly.
•  The Fed could target long-term interest rates.

Those are just a few of the other potential tools.  But don’t be fooled – there are other tools in the shed.  I am not sure they’re quite as powerful as the interest rate or traditional QE, but there are tools in there and given the dysfunction in Washington  and the low likelihood of big changes in fiscal policy, well, we better hope those tools work in the next downturn.