12 Coronavirus monetary policy
John H. Cochrane^1
Hoover Institution, Stanford University
A colleague and I were discussing the question, should the Fed lower interest rates in
response to the novel coronavirus?
More generally, suppose a pandemic gets serious and, either by choice or by fiat, a large
swath of the economy is shut down for a few weeks or months. What should the Fed, or
other economic policy do about it?
My first instinct was that the Fed should not lower rates. This is a classic supply shock,
and there is nothing more demand can do. What’s the point of encouraging more
spending if the stores are closed? Even giving people money doesn’t do any good if the
stores and factories are closed. The first job of a central bank should be to ask: “is this a
supply shock or a demand shock?”, and respond to demand shocks, not supply shocks.
This is like stoking demand at night or over the weekend.
But supply and demand aren’t so neatly distinguished. Maybe a supply shock creates
its own lack of demand. And a pandemic has demand effects too. People hunker up at
home and don’t want to go buy a new boat. One job of the central bank is to spy what
the natural real interest rate is and move the nominal rate accordingly, so there is no
force unsteadying inflation. Well, if the economy shuts down, people don’t want to
spend, since the stores are closed, so by definition they save (unless income is shut off).
People don’t want to borrow (except to roll over) for the same reason. The marginal
product of capital is nothing. So that argues for a pretty sharp fall in interest rates.
But as I think about it, the right answer is that this is the wrong question, and aggregate
supply and demand is the wrong framework for thinking about it. What happens if the
economy shuts down for a few weeks or months, either by choice or by public health
mandate? Shutting down the economy is not like shutting down a light bulb. It’s more
like shutting down a nuclear reactor. You need to do it slowly and carefully, or it melts
down.
1 This chapter first appeared on The Grumpy Economist blog.