One of the reason the Fed seems desperate to hike rates is they want ammunition to cut rates when the recession hits. Typically, the Fed cuts rates by 5 percentage points, but when the next recession hits, no such buffer will exist.

A Boston Fed simulation shows the central bank’s inability to cut rates by the usual amount would disproportionately hit certain states.

The Wall Street Journal reports States Face Crunch If Fed’s Tool Kit Is Limited in Next Recession.

>“Monetary buffers have been depleted,” said Eric Rosengren, president of the Federal Reserve Bank of Boston, which sponsored the conference this weekend where the research was released. A decline in rates over the past decade means the Fed’s recent experience of running out of room to cut them after lowering them to zero will not be “a one-time event,” he said.

>Mr. Rosengren and his co-authors, Boston Fed economists Joe Peek and Geoffrey Tootell, ran an experiment that shows how a recession might affect states assuming a traditional monetary-policy response, in which the Fed could cut its short-term benchmark rate by 5 percentage points.

>Then they looked at two other alternatives. In both scenarios, monetary policy couldn’t fully respond because the Fed had raised rates to only 2% before the hypothetical downturn. But in the last scenario, regulatory, state and local, and federal fiscal buffers were also depleted because they weren’t built up before the recession.

Per Capita Income Growth in Recession

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Some Unpleasant Stabilization Arithmetic

Please consider the Boston Fed study entitled Some Unpleasant Stabilization Arithmetic

Message from the Simulations

  • Not only are states differentially affected by recessions, they are also differentially affected by the extent to which policy buffers are insufficient to provide adequate countercyclical policy responses
  • Differences can be quite large
  • Still, effects are understated because they ignore feedback effects on UR from weak policy response
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The study cited "concerns about rising federal debt, limited state and local fiscal policy buffers, and any weakening of bank capital regulations."

States heavily dependent on agriculture fared better in the study. The West Coast, Illinois, and Pennsylvania suffered the most.

Mike "Mish" Shedlock