"The job of the central bank is to worry," according to former vice chair of the Federal Reserve Alice Rivlin. And for the last ten years, in response to the Great Recession, central banks around the world have worried. They slashed interest rates to record low levels, some even set policy rates below zero, as they sought to stimulate growth and create inflation. However, as central banks begin shifting policy from accommodative to expansionary, one starts to wonder if they have taken their foot off the gas too soon?

"There is a nagging dark cloud on the horizon: central banks seem to be declaring victory a bit too early in their battle to restore 'normal' inflation and interest rates," Bank fo America said in a research note clients. 

Inflation Is Falling, Not Rising

In the aftermath of the crisis, central banks reiterated that policy accommodation would not be normalized until inflation targets are met, most of which are 2 percent. By hitting 2 percent, the threat of deflation would have been alleviated. Fast forward to today. 

After raising the Fed funds rate three times in the last seven months the Fed is now tackling the task of reducing its balance sheet, the Bank of Canada raised its policy rate for the first time in nearly eleven years last week, and the European Central Bank (ECB) has begun to taper its policy. So inflation is back right? Well no, no it's not. (See also: How Will the Fed Reduce its Balance Sheet?)

Source: Bank of America

After hitting 2.7 percent in March, inflation in the U.S. has fallen every month reaching 1.6 percent in July. Not only is inflation going in the wrong direction, but inflation expectations are declining. The spread on the 10-year yield and 2-year yield fell below 1 percent in late July, coming within 5 basis points of the pre recession level. (See also: The Inverted Yield Curve Guide to Recession)

And it's not just inflation in the U.S.; global inflation is going in the wrong direction. 

No Wiggle Room

Should the unthinkable occur and another recession hit, global central banks have little to no room to fight it. From 2006 to 2009 the G-5 central banks cut rates by an average of 350 basis points to combat the crisis, and today as inflation undershoots and growth stalls the average policy rate for these five central banks is 50 basis points, according to Bank of America. 

As central banks begin to raise interest rates they aren't buying room to cut should a crisis arise. Rising interest rates will diminish inflation, not only increasing the probability of a recession but lowering nominal rates. Before the financial crisis the fed funds rate reached 5.25 percent, and with inflation above 3 percent, there was adequate room for the Fed to slash rates. Not so today. "If a major crisis emerges in the next several years, none of the major central banks will have adequate policy ammunition to deal with it," Bank of America said. 

"However, we believe they can solve some of their "low ammunition" problems by focusing on the end game: work hard to extend the expansion and make sure that they meet or exceed their inflation targets, creating space to move the nominal policy rate a reasonable distance away from zero."

Too Little Too Late

Even if the Fed can get the policy rate back towards neutral, it may not be enough. NYU professor Nouriel Roubini notes that the last two tightening cycles saw the neutral rate reach 6.5 percent and 5.25 percent respectively, and even then, the latter was not enough to halt the 2007-2009 crisis –  the Fed had to begin quantitative easing

"As the last few monetary-policy cycles have shown, even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively," Roubini wrote in a recent post. 

 

 

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