KW: We all know the outlines of how the Fed and other central banks responded to the financial crisis in 2008. First the Fed cut interest rates to zero and held them there for seven years. Then the Fed guaranteed every bank deposit in America regardless of the $250,000 limit on FDIC insurance. Next the Fed guaranteed every money market fund in America, even though such funds are not entitled to insurance or guarantees. Finally, the Fed did $10 trillion of currency swaps with the European Central Bank (to bail out Europe) and printed almost $4 trillion of new money under QE1, QE2 and QE3 to subsidize U.S. banks with risk-free profits. This extravaganza of zero rates, guarantees, swaps and money printing worked to ease the panic and prop up the financial system. But it did nothing to restore growth to its long-term trend or to improve personal income at a pace that usually occurs in an economic expansion. Now, after a 10-year expansion, policymakers are considering the implications of a new recession. There’s only one problem: Central banks have not removed the supports they put in place during the last recession. Interest rates are up to 2.5%, but that’s far lower than the 5% rates that will be needed so the Fed can cut enough to cure the next recession. The Fed has reduced its balance sheet from $4.5 trillion to $3.8 trillion, but that’s still well above the $800 billion level that existed before QE1. In short, the Fed (and other central banks) have only partly normalized and are far from being able to cure a new recession or panic if one were to arise tomorrow. It will takes years for the Fed to get interest rates and its balance sheet back to “normal.” Until they do, the next recession may be impossible to get out of. The odds of avoiding a recession until the Fed normalizes are low. The Fed cannot escape the corner they have painted themselves into.

Source: Growth stumbling but central bank arsenals are near-empty – Reuters