When scholars write the history of the policy response to COVID-19, they will say the Federal Reserve failed in its primary responsibility: maintaining monetary stability.
The Fed’s current plan to contain the economic fallout caused by the pandemic amounts to $2.3 trillion in asset purchases. Some of this is conventional monetary policy. But it also includes a lot of direct lending to non-financial businesses, as well as state and local governments. These new activities may very well be illegal, but that has not seemed to slow the Fed down.
The Fed’s approach, which focuses on balance sheets rather than conventional aggregate demand stabilization, suggests Fed officials have lost sight of their primary role. We use money to buy goods and services. Everything trades against money. That means money has no market of its own, in which it is independently priced. Hence, a mismatch between money supply and money demand can have real economic effects.
In brief, an excess demand for money results in an excess supply of goods and services. Aggregate demand declines. Real output falls. People lose their jobs. Society is worse off. And it is all because there is too little money.
The Fed’s job is to prevent that; to ensure there is neither an excess demand nor an excess supply of money. But, by the looks of it, the Fed is failing to do so.
COVID-19 is, first and foremost, a negative supply shock. Voluntary social distancing and government lockdowns mean resource owners are less willing to supply land, labor, and capital to productive processes. There’s nothing the Fed, or any countercyclical policy, can do about that. Production in general has become costlier. There will be no full recovery until the risk associated with the disease declines and the policies imposed to slow the spread are lifted.
Monetary policy cannot reduce the risk of disease. It cannot lift stay-at-home orders. But it can make matters worse, by failing to stabilize aggregate demand.
Has the Fed permitted aggregate demand to fall? Markets suggest they have. If aggregate demand were stable, a negative real shock would put upward pressure on inflation. The logic is straightforward: costs rise as goods and services become more scarce.
In fact, market participants are currently pricing in a lower rate of inflation, not a higher rate as would be expected given the negative supply shock.
Good macroeconomic students will recall the Fisher equation, which states that expected inflation is equal to the nominal interest rate minus the real interest rate. The TIPS spread is the difference between the rate on traditional Treasuries, a nominal interest rate, and Treasury inflation-protected securities, a real interest rate. Since the underlying assets have the same issuer and duration risks, the TIPS spread is often used as a measure of inflation expectations.
Look at what has happened to inflation expectations over the last two months. From May 2019 until March 2020, expected inflation hovered around 1.6 percent. At the beginning of March, however, it fell precipitously, to a low of 0.16 percent. Since then it has partially recovered, and currently stands at 0.84 percent. But that is still 76 basis points below the pre-crisis trend. That amounts to a decline in inflation expectations of 47.5 percent!
The magnitude of the fall in expected inflation means a great deal. If the Fed were doing its job (i.e., stabilizing aggregate demand), the rate of inflation would rise temporarily to account for the negative supply shock. Instead, market participants expect inflation to be lower. They expect the Fed will fail to stabilize aggregate demand. And they are putting their money where their mouths are.
Given market expectations, the Fed would do well to focus on monetary stability. Instead, it has taken on a host of preferential credit allocation schemes. It is purchasing loans made to small businesses and extending credit to large (non-bank!) corporations. It is backstopping fiscally irresponsible local governments. In other words, the Fed is too busy picking winners and losers to focus on monetary stability.
Sadly, this isn’t new. The Fed has played a much bigger role in the allocation of credit since the 2007-8 financial crisis. Then, the Bernanke Fed significantly increased the Fed’s balance sheet with toxic assets and loans to banks while failing to stabilize aggregate demand. In the time since, with the passage of Dodd Frank and an increased reliance on macroprudential regulation, the Fed’s scope has expanded even further.
Policymakers keep asking the Fed to do more and more. But the Fed is not very good at those things. Instead, the Fed should be limited to guaranteeing monetary stability. And it should accomplish that by credibly maintaining a nominal anchor.
The market allocates resources. The central bank provides liquidity. That’s the institutional division of labor we should strive for.
The Fed has refused to do the sensible thing. Rather than focusing on monetary stability, it has embarked on a host of misguided experiments that threaten the long-run integrity of markets. Now is the time to rein the Fed in.
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