I have been asked about what the Federal Reserve should do in response to ‘corona shock’.
So here we go – I suggest the Federal Reserve immediately put out the following statement:
“The Federal Open Market Committee (FOMC) notes that the global shock from the spreading of the corona virus significantly has changed financial market expectations regarding the outlook for the US economy and particularly regarding financial and monetary conditions.
The FOMC also notes that financial market expectations regarding the outlook for nominal spending growth and inflation have deteriorated significantly and to such a degree that the US economy risks entering a potentially severe recession in the coming quarters and that there is a serious risk that inflation will further undershoot the Federal Reserve’s 2% inflation in the medium-term.
Consequently, the Federal Reserve will take imitate policy actions to ensure nominal stability and to avoid a recession.
First, of all the Federal Reserve will immediately undertake unlimited asset purchases in global bond, FX and commodity markets to ensure that market inflation expectations measured as TIPS inflation expectations (2, 5 and 10 year horizons) will permanently be in the range of 2-3%.
The policy is open-ended and permanent. Furthermore, the Federal Reserve will no longer try to ‘peg’ the Federal Funds rate. Rates will be determined by market forces.
Second, the FOMC wants to remind market participants that the Federal Reserve has the ability to expand the dollar money base unlimited to offset any increase in the demand for base money and to ensure hitting the 2% inflation target on any time horizon.
Third, the Federal Reserve will act in accordance with its mandate as a lender of last resort to the banking system and provide dollar liquidity to any financial institution domestic or foreign with proper collateral.
Fourth, the Federal Reserve is already in close contact with major central banks around the world to ensure that if necessary ample dollar liquidity is provided to the global financial system to avoid an unwarranted and disruptive hoarding of dollars. If necessary, the Federal Reserve will expand dollar-swap agreements with central banks around the world.
Finally, the Federal Reserve is closely monitoring exchange rate developments, commodity prices as well as global inflation expectations so to stand ready to offset any potential negative shock to dollar-demand. The Federal Reserve will under no circumstances allow a potentially deflationary decline in money-velocity.
The Federal Reserve cannot mitigate the disruptions to the global supply chain resulting from the coronavirus, but the Federal Reserve will use all powers at its disposal to ensure that nominal stability is maintained.”
This is not my “optimal” policy proposal (that would include a NGDP target), but it is nonetheless what I believe to be the “right” policy given the Federal Reserve’s present policy framework.
John Hall
/ February 28, 2020No mention of rate cuts?
Also, typo for “Forth” instead of “Fourth”.
Lars Christensen
/ February 28, 2020The answer is here: “Furthermore, the Federal Reserve will no long try to ‘peg’ the Federal Funds rate. Rates will be determined by market forces.”
My suggestion is that the Fed shouldn’t use interest rates to set monetary conditions.
Steve Ambler
/ February 28, 2020Pretty major operational change. I’m guessing you would also get rid of interest payments to banks on excess reserves.
Lars Christensen
/ February 28, 2020Thanks Steve, yes it is a major operational change but this would complete remove discretion and perfectly peg inflation expectations.
And yes, even though I don’t put it in the statement I certainly would get rid of interest on excess reserves.
I was actually thinking about making a small video on the problem with New Keynesian models where we assume that policy either move with the changes in the input in the policy rule or in a smoothed fashion is that it really doesn’t capture the fact that central banks don’t acknowledge the shock before after a fairly long period and hence makes the shock worse.
Justin
/ March 2, 2020This is good as Far as the Fed goes, but I worry that the Chuck Norris Effect is insufficient when the very structure of the economy changes, or is expected to change (most people stay indoors in Q2). I think your policy gets us back on track when the dust settles, but we also need to minimize chaos in Q2 and Q3 2020.
What happens to people who work at the “Starbucks” of the world, and to their loans? Customers stay away, shops are put on reduced hours or temporarily closed. Americans have very weak cash buffers, well into the middle class actually. I would favour pairing your policy with a Treasury stimulus, announced at the same time at a joint press conference. The Treasury will mail $1,500 checks to every adult citizen/Permanent Resident for the months of March, April and May. We all know the arguments against fiscal stimulus, but in this case, the goal isn’t so much to stimulate AD, as to make sure people with fragile balance sheets can keep their loans out of delinquency through reduced payment. The Treasury should be refinancing debt at this low rates anyway, we can afford to do this.
Hourly workers in the service industries are extremely fragile in this situation, it’s fairly cheap to make them less fragile, and forestall a inter-bank lending crisis that might arise when 70% of consumer debt starts going into delinquency. Remember, apparently 70% of household have less than $1000 in cash on hand.
Shaun
/ March 2, 2020Hi Lars,
Does the Federal Reserve have the autorithy to buy commodities? And a second question would be how the rest of the world react to Fed buying foreign bonds? That could mean a weaker dollar and I suppose some countries will not like it at all. Thanks.