Harvard economist Martin Feldstein warns that the Federal Reserve will essentially be powerless to help the nation’s economy when the next recession hits.
“A downturn brought on in the next few years by rising long-term interest rates would likely be deeper and longer than your average recession,” Feldstein wrote in The Wall Street Journal.
“Unfortunately, there’s nothing at this point that the Federal Reserve or any other government actor can do to prevent that from happening,” he wrote.
“If the P/E ratio of the S&P 500 regresses to its historical average, 40% below today’s level, $10 trillion of household wealth would be wiped out. The past relationship between household wealth and consumer spending suggests such a decline would reduce annual spending by about $400 billion, shrinking gross domestic product by 2%. Add in the effects on business investment, and this spending crunch would push the economy into recession,” he warned.
“Most recessions are short and shallow, with an average of less than a year between the start of the downturn and the beginning of the recovery. That’s because the Fed usually responds to recessions by cutting the federal-funds rate substantially. But if one hits in the next few years, the Fed will not have enough room to cut rates, as the fed-funds rate is expected to rise to only 3% by 2020,” he predicted.
“There also won’t be much room for a major fiscal intervention. Federal deficits are expected to exceed $1 trillion annually in the coming years, and publicly held federal debt is predicted to rise from 75% of GDP to nearly 100% by the decade’s end,” he wrote.
However, the top U.S. central bank official isn't as pessimistic about the economic future.
The U.S. economy does not face a large chance of a recession in the next two years and the Federal Reserve plans to keep gradually raising interest rates, Fed Chairman Jerome Powell said Thursday, Reuters reported.
Asked whether the narrowing gap between short-term and long-term interest rates points to an impending economic downturn, Powell said the U.S. central bank's analytical models suggest the economy will keep growing.
"There's no reason to think that the probability of a recession in the next year or two is at all elevated," Powell told a gathering of business people.
An inverted yield curve -- when short-term rates on U.S. Treasury securities rise above the long-term rates -- is typically regarded as a sign of a coming recession.
The Fed raised interest rates on Wednesday in a bid to keep U.S. inflation from eventually rising too high, in its third rate hike this year. Powell on Thursday repeated his view that rates need to keep climbing.
"My colleagues and I believe that this gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans," he said in a speech to Rhode Island business leaders hosted by Democratic Senator Jack Reed on Capitol Hill, before taking questions.
Powell's brief speech covered much of the ground he tread on Wednesday in his opening statement at a news conference after the Fed announced its rate hike.
Powell on Wednesday said that the U.S. economy was in a "particularly bright moment" as policymakers forecast another three years of growth, low unemployment and stable inflation.
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