Fed Will Trap U.S. Economy in Recession With 0% Interest Rates

• Markets are pricing in near-100% odds the Federal Reserve will drive interest rate targets down to zero percent next week.
• If that happens, the Fed will trap itself between a recession and runaway inflation should prices skyrocket while GDP falls.
• That is a horrific situation for the economy to be in: stagflation. It happened in the U.S. before, and it could easily happen again.

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.

Does the Fed Pass Ben Bernanke’s Firepower Test?

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.”

Forward guidance means simply promising to keep rates low in the future to give markets some confidence. And even teasing markets about possible negative interest rates like they currently have in Japan:

The Fed should also consider maintaining constructive ambiguity about the future use of negative short-term rates, both because situations could arise in which negative short-term rates would provide useful policy space.

But if the Fed bails out the economy one more time using Bernanke’s approach, there won’t be any room left to maneuver away from inflation or recession. That would trap the economy in stagflation, which happened in the 1970s to the surprise of all mainstream economists. It was a very dark time for America.

Low Interest Rates, Inflation, And Recession

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.

In its January edition, The Economist warned:

only America looks remotely close to passing [Bernanke’s] firepower test.

The reason? Foreign central banks have cut their interest rates too low to leave any wiggle room left.

If the Fed cuts rates to zero like markets believe it will, that will put the U.S. in the same boat as the rest of the world.

Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com.