Earlier today, the market’s confidence that the Federal Reserve will slash its benchmark interest rate target to zero by next week temporarily soared to nearly 95%. But if the Fed cuts interest rates all the way to zero, there’s a real danger of inflation making the financial crisis worse. Because the economy could slip into recession despite monetary intervention with record-low interest rates. Then the Fed won’t be able to raise rates to whip inflation if prices begin to get out of control. That would make the recession worse. Yet it won’t able to keep rates low either to fight the recession. That will hurt a lot of people with high prices.
A nagging question that has festered since the financial crisis is whether the Federal Reserve could save the U.S. from another recession. Would the combination of low interest rates and quantitative easing (buying up massive amounts of bonds with money created out of thin air) work again? Not every economist is so sure. But former Federal Reserve chair Ben Bernanke argued it could in a January paper published by the Brookings Institution. In the paper, “The New Tools of Monetary Policy,” Bernanke addresses the fact that interest rates are much lower now than before the 2008 financial crisis. Interest rates were at 5.25% before the last recession. The Fed’s target rate was 1.75% before last week’s emergency cut by half a percent down to 1.25%.
That doesn’t leave the central bank much room to cut any further to grease the axles and keep the economy’s wheels turning if markets continue to slow down. Ben Bernanke argues the Fed can still achieve the equivalent of 3% in rate reductions through a combination of more quantitative easing and “forward guidance.” When interest rates are low, inflation – the price of goods and services – generally increases. Once there’s no room left to cut interest rates any further, the Federal Reserve will have painted the economy into a corner. The central bank would trap us between an economic Scylla and Charybdis: recession and inflation.