Before the Great Recession, traditional countercyclical monetary policy, lowering short-term interest rates as the economy weakens, was viewed as the primary tool for addressing economic downturns. However, after the experience of hitting the effective lower bound (ELB) for an extended period of time, we became much more aware of the possible limitations of relying too heavily on traditional countercyclical monetary policy. The challenges to effective countercyclical monetary policy presented by the possibility, in fact the probability, of returning to the ELB in future recessions have highlighted the potential importance of nonmonetary policy tools, such as federal fiscal policy, state and local fiscal policy, and even bank regulatory policy, as necessary sources of countercyclical stabilization policy. However, to implement such policies effectively, policymakers must be both willing and able to use them, which requires both the desire to use the available countercyclical tools and policy buffers of a size sufficient for them to be useful. Thus, a current concern is the extent to which the United States has sufficient policy buffers to offset a large adverse shock.
This paper highlights that limitations in using short-term interest rates to combat economic downturns is likely to be a recurring problem, given the increased likelihood of the federal funds rate hitting the ELB. We explicitly consider monetary and nonmonetary policy buffers to gauge how resilient the economy is likely to be in the next recession. We focus on individual US states, which allows us to evaluate how critical the various policy buffers are at the individual state level, while recognizing differences in the extent to which states will be impacted, both by countercyclical policies and by limitations imposed by insufficient policy buffers, given the differences in such factors as states’ sensitivities to countercyclical monetary and federal fiscal policies.
From a policy perspective, more attention should be given to establishing appropriate policy buffers to mitigate future shocks. For state and the federal governments, we highlight the potential downside of using up financial capacity during this recovery. For bank regulation, we highlight the importance of maintaining a well-capitalized and resilient banking system. For monetary policy, considering how best to respond to the increased likelihood of hitting the ELB in the future—and either building a larger monetary policy buffer or being more willing to aggressively use nontraditional tools—will be essential.
