What should Fed monetary policy be in response to COVID-19, particularly if it becomes a global financial crisis?
Mostly summarizing/quoting this podcast episode: macromusings.libsyn.com/scott-sumner-o…
Building off this thread, which gives some historical context:
Mostly summarizing/quoting this podcast episode: macromusings.libsyn.com/scott-sumner-o…
Building off this thread, which gives some historical context:
COVID-19 was initially a supply shock (e.g supply chains)
What markets are really worried about is a demand shock.
This negative supply shock is probably reducing expected growth in the global economy, and that's putting downward pressure on the equilibrium interest rate
What markets are really worried about is a demand shock.
This negative supply shock is probably reducing expected growth in the global economy, and that's putting downward pressure on the equilibrium interest rate
If the Fed doesn't reduce interest rates along w/ a fall in the equilibrium rate, then monetary policy will get unintentionally tighter, & that reduces aggregate demand
It's incorrect to say the Fed should just stand pat & not adjust interest rates b/c it's a supply side problem
It's incorrect to say the Fed should just stand pat & not adjust interest rates b/c it's a supply side problem
And it's not correct to say that monetary policy can solve supply side problems either.
This supply side problem could then trigger a change in aggregate demand and monetary policy needs to adjust to prevent that secondary effect on aggregate demand. (e.g housing in 2008)
This supply side problem could then trigger a change in aggregate demand and monetary policy needs to adjust to prevent that secondary effect on aggregate demand. (e.g housing in 2008)
The initial supply shock is similar to trade war last year.
When there's a disruption to manufacturing supply chains, that tends to reduce business investment, which puts downward pressure on demand for credit, which (usually) reduces equilibrium interest rates.
When there's a disruption to manufacturing supply chains, that tends to reduce business investment, which puts downward pressure on demand for credit, which (usually) reduces equilibrium interest rates.
Also, w/ COVID, there's also a lot of uncertainty in the global economy.
And when there's uncertainty, there's a rush for safe assets, people buy treasury bonds, that also puts downward pressure on interest rates.
So you have this downward pressure on global interest rates.
And when there's uncertainty, there's a rush for safe assets, people buy treasury bonds, that also puts downward pressure on interest rates.
So you have this downward pressure on global interest rates.
You can think of the equilibrium rate as the rate consistent w/ stable economic growth & consistent w/ the feds targets for inflation & employment.
If the Fed sets its policy rate too high or too low, we go off track
This makes ppl think Fed should do nothing, but it's untrue
If the Fed sets its policy rate too high or too low, we go off track
This makes ppl think Fed should do nothing, but it's untrue
Doing nothing is doing something
If you want money supply or interest rates to be the same as before, you have to do something to get it there
if velocity slows, to maintain the same monetary policy, you have to increase money supply to offset effects on declining velocity
If you want money supply or interest rates to be the same as before, you have to do something to get it there
if velocity slows, to maintain the same monetary policy, you have to increase money supply to offset effects on declining velocity
B/c the dollar plays a large role in the global economy, changes in US monetary policy have ripple effects on other countries.
If Fed doesn't cut rates fast enough, monetary policy gets unintentionally tighter. Side effect of tighter money is the dollar appreciates in fx market.
If Fed doesn't cut rates fast enough, monetary policy gets unintentionally tighter. Side effect of tighter money is the dollar appreciates in fx market.
This also happened in the second half of 2008 during the financial crisis:
The dollar appreciated strongly, and for countries where their currencies are linked to the dollar & that have borrowed a lot of money in dollars, this can become a very big burden.
The dollar appreciated strongly, and for countries where their currencies are linked to the dollar & that have borrowed a lot of money in dollars, this can become a very big burden.
What should Fed do if it becomes a global financial crisis?
Tactics:
In 2008, the Fed extended a number of currency swap lines to a number of central banks across the world. Prob same again
Cutting interest rates, QE to address immediate crisis for liquidity, need for stimulus
Tactics:
In 2008, the Fed extended a number of currency swap lines to a number of central banks across the world. Prob same again
Cutting interest rates, QE to address immediate crisis for liquidity, need for stimulus
Strategy:
GDP level targeting, but that's unrealistic, so instead level targeting of inflation.
Level targeting, as opposed to just inflation targeting, forces Fed to be much more serious.
If Fed overestimates inflation, they actually have to make up for past mistakes
GDP level targeting, but that's unrealistic, so instead level targeting of inflation.
Level targeting, as opposed to just inflation targeting, forces Fed to be much more serious.
If Fed overestimates inflation, they actually have to make up for past mistakes
Many central banks have had excessively contractionary monetary policy, which has led to inflation & growth not hitting their target.
Low inflation & low growth puts pressure on interest rates
As interest rates fall, ppl think central banks have easy monetary policy.
Low inflation & low growth puts pressure on interest rates
As interest rates fall, ppl think central banks have easy monetary policy.
Which is why people think there aren't many levers for monetary policy. But that's wrong. These low interest rates (& QE) are really a reflection of previous tight money
We have to ask ourselves two questions:
We have to ask ourselves two questions:
1/ what kind of target do we want for inflation or nominal GDP growth?
The higher the target, the higher the interest rate, & the less QE you'll have to do, b/c ppl won't want to hold as much cash
Want low inflation rate? (e.g. Japan, Switzerland) Do QE b/c ppl will hoard cash
The higher the target, the higher the interest rate, & the less QE you'll have to do, b/c ppl won't want to hold as much cash
Want low inflation rate? (e.g. Japan, Switzerland) Do QE b/c ppl will hoard cash
2/ Are we going to tell central banks to do whatever it takes to hit their inflation / growth targets?
Or would we rather give this to fiscal policy?
Monetary policy is less costly b/c it neither adds to our national debt nor puts a big tax burden on future generations
Or would we rather give this to fiscal policy?
Monetary policy is less costly b/c it neither adds to our national debt nor puts a big tax burden on future generations
Also less costly than fiscal policy b/c if the Fed buys a lot of assets, usually it will make a profit (they did in 2008)
But even if they make a modest loss, that loss is going to be a much smaller burden on future taxpayers than fiscal stimulus would be
But even if they make a modest loss, that loss is going to be a much smaller burden on future taxpayers than fiscal stimulus would be
Maybe there's a chance that, if interest rates fell to zero and they couldn't be cut any further, they Fed could widen the range of assets (e.g. Treasury securities, corporate bonds) they could buy wide enough such that they'd have enough assets to hit a 2% inflation target.
We keep seesawing but each time is better than before.
Overreacted on expansionary side in 60s/70s
In last decade, overreacted on contractionary side
But 2008 was much better recovery than 1929.
Fed should be more responsive to market conditions than Phillips Curve models
Overreacted on expansionary side in 60s/70s
In last decade, overreacted on contractionary side
But 2008 was much better recovery than 1929.
Fed should be more responsive to market conditions than Phillips Curve models
In conclusion: Desired response is level targeting, ideally of GDP but inflation level targeting will do.
Additionally, Fed should cut interest rate target b/c I believe equilibrium interest rate has fallen, but cutting interest rates without level targeting isn't enough.
Additionally, Fed should cut interest rate target b/c I believe equilibrium interest rate has fallen, but cutting interest rates without level targeting isn't enough.
