When the Next Recession Occurs: Will the Federal Reserve Resort to Quantitative Easing?

The Federal Reserve, like the European Central Bank (ECB), has turned to a tighter monetary policy and interest rate hikes, signaling its preference against quantitative easing (QE) as a policy tool. However, in cases of severe economic downturns, the Fed might be compelled to reintroduce QE to address financial sector liquidity needs and stabilize the economy. This article explores the likelihood of QE being implemented in the next recession, the reasons behind its potential use, and its potential impact.

Why the Federal Reserve May Turn to QE Again

During the last recession, the Federal Reserve used QE as a crucial tool to stimulate economic activity and support the banking sector. The success of these measures laid the groundwork for their potential future use in stabilizing the economy. Specifically, the Federal Reserve is unlikely to reconsider QE until inflation is perceived to be under control and at or below target levels. With current low unemployment rates, the Fed's focus remains on curbing inflation rather than easing monetary conditions.

The Comprehensive Role of QE in Economic Recovery

Quantitative easing, as implemented by the Fed during the last recession, succeeded in reviving the economy to its potential growth rate and bolstering the banking sector. When the economy faces severe challenges, particularly in terms of debt, QE can play a vital role in injecting liquidity into the financial sector. This process ensures that new debt can be issued without crowding out other demands for money and driving up interest rates, which could lead to economic hardship and, in severe cases, financial distress.

The Likely Need for QE in the Next Recession

The upcoming recession could necessitate the reintroduction of QE, especially if the downturn is deep and significant. The current level of US debt makes it highly probable that the next recession will lead to massive budget deficits, potentially reaching 50% of the federal budget. In such a scenario, the government might struggle to honor its debt obligations without resorting to selling bonds or treasuries at abnormally high interest rates. The sale of these bonds in a weak market could cause their prices to plummet and yields to soar, exacerbating the financial situation.

Possible Outcomes and Their Impact

The Federal Reserve's potential need for QE stems from the severity of the next recession. While a relatively mild recession might not require this intervention, a deep and widespread downturn could necessitate its use. The Fed's primary concern is maintaining financial stability and ensuring the economy can recover. The failure to do so could lead to a situation akin to the pre-Great Depression period, where economic recovery took decades. The stock market could lose more than 75% of its value, and the country might have to restructure its debt, potentially leading to significant social and economic disruptions.

Reforming the Economic Landscape Post-Next Recession

The immediate aftermath of the next recession could involve a period of significant economic hardship. Widespread defaults on mortgages and bank failures could test the FDIC's ability to cover its guarantees, potentially leading to an even greater level of national debt. To avoid a prolonged economic downturn, the government might need to consider drastic measures, such as debt restructuring, which could involve writing off a significant portion of the debt at a fraction of its face value. This action, while necessary for economic recovery, could have significant implications for US citizens and the broader economic landscape.

Conclusion

The Federal Reserve's approach to monetary policy is likely to remain focused on inflation and economic stability in the short term. However, the potential for a severe recession could compel the Fed to revisit quantitative easing as a tool to stimulate recovery. Understanding the potential need for and implications of QE is crucial for both policymakers and the public, as it could significantly shape the economic landscape in the coming years.