Robert Hetzel on the monetary response to Covid19

There are few economists that have had a bigger influence on my thinking about monetary matters than former Richmond Fed economist Robert Hetzel.

Bob is not only one of my biggest intellectual heroes, but also a very a good friend and I am therefore extremely happy that he has allowed to publish some of this insights and thoughts on Fed’s 50bp ’emergency’ rate cut today.

Lars Christensen

Fed and Covid19

By Robert Hetzel

Cutting the funds rate just before an FOMC meeting sends a strong but not necessarily appropriate message.  The fact that the cut came without the discussion from the regional Bank presidents of their respective regions that would come routinely at an FOMC meeting suggests that the FOMC was responding to the decline in the stock market.

That turned out badly for the Fed in October 1987 when the market fell 20% and the FOMC cut the funds rate.  By spring, it was obvious that the economy had continued to grow unsustainably fast.  A more disagreeable interpretation of the last cut is that pre-meeting cuts or messages from the chair that lock the FOMC into cutting are a throwback to the Burns era.  At times, Burns would engineer a cut in the discount rate just before an FOMC meeting to lock in a funds rate cut thereby dispensing with opposition from within the FOMC.

To be clear, the reduction in the funds rate could turn out to be completely appropriate.  Starting with the July 2019 meeting, the FOMC lowered the funds rate by ¾ a percentage point.  It did so based on a forecast that disruption to international trade would weaken the world economy and adversely affect U. S. growth.   If the Trump administration had not pulled back on its tariff threats out of concern for growth in the 2020 election year, the forecast could have been validated.  In a perverse sense, the Fed was “lucky” in that the Covid19 virus validated that forecast and the earlier ¾ percentage point cut.

The world would tear apart if central banks exacerbated a coming recession with contractionary monetary policy.  One analogy is the GM strike in 1959 that produced a sharp decline in output.  The FOMC attributed the weakness in the economy to the strike and missed the fact that monetary policy was contractionary.  The result was a recession in 1960.

As usual, models can organize a discussion without offering answers.  The Covid19 disruption is a negative productivity shock.  If households see the shock as transitory, they draw down their rainy-day savings and there are no consequences for the natural rate of interest.  If households see the shock as long lasting and become pessimistic about the future, they will want to save more.  Equivalently, they will want to transfer consumption from the present to the future.  The intertemporal price of consumption (the price of current consumption in terms of future consumption) will have to decline (the real interest rate decline) to maintain current aggregate demand.

What about the argument that the FOMC can always reverse its cuts in the funds rate, which are now 1 ¼ percentage points?  The first problem is that the FOMC is always reluctant to move at inflection points demarcating persistent reductions to possible persistent increases.  The FOMC is always concerned about how markets will extrapolate the initial increase to future increases.

The second problem concerns whether markets will see an increase as a change in strategy.  The current strategy entails forward guidance that lowers the market’s expectation of the future funds rate path.  That guidance is a result of Powell’s promise not to raise the funds rate until inflation persistently and significantly overshoots the FOMC’s two-percent inflation target.  Markets see no inflation on the horizon and infer that a relatively low funds rate can be maintained for a considerable if not indefinite period.  The vagueness of the criterion of a persistent overshoot in inflation allows almost unlimited discretion to the chairman.

Given all the publicity generated by the FOMC’s monetary policy review, it would be useful to have some discussion of the current strategy.  I assume the current strategy makes the funds rate target into a one-way downward ratchet until inflation rises well above two percent.  Given the bad news first about trade and now about the Covid19 virus, the strategy has worked.  What does the FOMC do with good news?


Books by Robert Hetzel:

The Monetary Policy of the Federal Reserve: A History
The Great Recession: Market Failure or Policy Failure? 




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