Back in 2008, the Fed thought the “real problem” was banking distress, and instituted a set of policies based on that assumption. These policies were aimed at injecting reserves into the banking system without the reserves leaking out and stimulating the broader economy. That’s precisely why a policy of interest on reserves was adopted on October 8, 2008.
In fact, the real problem was nominal—falling nominal GDP. When the Fed figured that out in 2009, they began to gradually move toward a more expansionary monetary policy. But by this time it was too late to prevent a severe recession.
Something similar may be happening again. Here’s Greg Ip of the WSJ:
In a liquidity crisis, otherwise healthy firms collapse because they can’t access credit. The Fed can resolve such a crisis because it can print and lend unlimited amounts of money. In a solvency crisis, companies can’t survive no matter how much they can borrow: they need more revenue. The Fed can’t solve that. [Emphasis added]
Ip is describing the Fed’s current view, but this view is not correct. “More revenue” is exactly the problem that the Fed can and should be addressing. They need to sharply boost NGDP expectations for 2021 if they don’t want a major solvency crisis to occur.
If we don’t luck out on the medical front, this could turn into a deep depression under current monetary policy. (Fiscal policy is largely ineffective, and hardly worth discussing.) The Fed needs to shift to level targeting, and also a “whatever it takes” approach to getting NGDP (or price level) expectations back up to trend by 2021.
In the very near term, a fall in NGDP is inevitable. But the Fed needs to insure there is adequate spending once the lockdown ends. If that means stagflation in 2021, then so be it. There are much worse things than stagflation, and under current policy we’re likely to see one of those “much worse things” in 2021.
HT: David Beckworth
READER COMMENTS
Michael Sandifer
Apr 30 2020 at 7:32pm
Good comments. I’ll only add that we never left the last depression.
Mark Bahner
Apr 30 2020 at 8:34pm
?!
Unemployment was near all-time lows, the SP 500 was at an all-time high, GDP was growing (although not very fast). How can all those things be true if we “never left the last depression”?
P Burgos
Apr 30 2020 at 11:07pm
Doesn’t a booming economy have high wage growth, by definition? If that is true, and if wage growth never fully recovered, than it should also be true that the economy never fully recovered from the recession of 2008-2009.
Mark Z
May 2 2020 at 11:58am
Wages were growing, if belatedly. But in any case, I don’t think wage growth is an indicator of whether you’re in a recession. Productivity may plateau and real wages could become static (as they were for most of human history). That wouldn’t mean we’re in a never ending recession.
Thomas Hutcheson
May 1 2020 at 10:59am
TIPS break even spread never reached the equivalent of 2% p.a. PCE. Probably better said, “never fully recovered from the 2008 financial crisis.”
Lorenzo from Oz
Apr 30 2020 at 10:43pm
I know I am preaching to the choir, but how can it be so hard for central bankers to get their head around the idea that anchoring total spending expectations matters?
I realise that Australia being south of the equator means our experience does not count, and if it does then being China’s quarry means it does not count (even though we have ALWAYS been a quarry but never before had record periods without a technical recession), but the general point still remains.
I wonder if Greenspan’s “out and then back and gone” monetary stimulus after the 1987 stock market crash that does not show up in the stats unless you really look, so therefore disappearing down the memory hole, is also a factor.
P Burgos
Apr 30 2020 at 11:11pm
Funny thing is, Trump, in his vulgar and very basic way, probably agrees with Sumner.
I wonder what Biden’s views are on monetary policy.
I am also baffled why Presidents don’t try to pack the Fed with folks eager to conduct expansionary monetary policy.
P Burgos
Apr 30 2020 at 11:13pm
To put it another way, this Fed is the Fed that Trump created, at least in part. And it seems that the problem with the Fed is its personnel. Trump has consistently expressed a view that monetary policy is too tight, but didn’t put the people in place to right that situation.
Scott Sumner
May 1 2020 at 7:13pm
I think it’s misleading to suggest that Trump agrees with me. I favor steady 4% growth in NGDP. That’s not Trump’s preference. He thought money was too easy in 2016.
Rajat
May 1 2020 at 12:35am
Is that really the Fed’s view or just Ip’s (I can’t access the story)? And if the Fed’s, is that a view they’ve expressed just recently or a longer-standing one? I ask because until yesterday, the US stock market had been rising strongly. I know I’ve asked you this at moneyillusion and you’ve responded, but it seems odd to me that stocks remain so high if the risk of a depression or even serious & sustained recession is growing. You said previously that one could reconcile the equity and bond markets by considering that the pandemic might have lowered real equilibrium interest rates substantially and that the equity market may be taking account of the fact that it was too pessimistic in 2001-2 and 2008-9. But then, what could the S&P500 have been anticipating in mid-late March when it got down to 2200 (from a late February peak of nearly 3400), compared to 2900 now? A ‘super-depression’? Do you think there’s something to the view of some financial market watchers that the bond market is smarter (ie quicker) than the equity market?
Regarding the old liquidity-solvency dichotomy (based on Bagehot, I presume), many economists in Australia and elsewhere have pushed the idea of government ‘bridging’ assistance to help firms manage their cashflows until the restrictions are over – which might be relatively soon down here. While in principle, firms might be able to borrow from banks or others if NGDP were expected to return quickly to trend, do you accept there may be financial market imperfections that inhibit a fast-enough market response to keep otherwise-profitable firms solvent and that warrant government transfers or loans to businesses during a major real shock like the present one? In other words, ‘this time is different’? That’s not to say such transfers could be a substitute for adequate expected NGDP; but a complement? And I’m not suggesting the Fed (and others) don’t (incorrectly) see them as substitutes. I hope that makes sense.
Scott Sumner
May 1 2020 at 7:17pm
Yes, all that is possible. There’s obviously great uncertainty right now, and I don’t claim to know exactly what’s going on in the markets. I just feel I know enough to be confident that monetary policy should be at least somewhat more expansionary, and that this would help credit markets. Whether additional direct financial aid is needed is an open question. I have yet to see the argument for why a weak junk bond market is a public policy problem.
Thomas Hutcheson
May 1 2020 at 11:14am
A fall in NGDP may be inevitable in the short run (although I’d like to see that explained) but not a fall in inflation expectations. Why isn’t the Fed pumping out enough money to get the TIPS 5 year inflation expectation at least up to the equivalent of 2% PCE inflation? That rate has not been above even 2% CPI since 2018 and has not been above 1% since March 8. Isn’t it obvious that when supply falls, prices should rise?
Scott Sumner
May 1 2020 at 7:18pm
I agree.
Comments are closed.