The Fed is trying to solve the wrong problem
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