Scott Sumner on How Central Banks Should Respond to the Coronavirus Threat

Episode Summary

Executive Summary: Scott Sumner argues the coronavirus shock is initially a supply shock but quickly becomes a demand problem through lower equilibrium rates, falling velocity, and financial spillovers. He says the Fed should cut rates, consider stronger level targeting or average inflation targeting, and use market signals and emergency tools to prevent passive tightening and global dollar stress.

Main Topics: Coronavirus as supply shock with demand spillovers (Priority: 5/5): Sumner distinguishes the virus itself as a supply disruption from the broader market reaction, which he says is a negative demand shock that can depress spending and employment if policy does not adjust. *Neutral rate (r) and passive tightening (Priority: 5/5): He explains that if the equilibrium real rate falls but the Fed keeps its policy rate unchanged, monetary policy becomes tighter unintentionally, deepening the downturn. Market indicators and nominal GDP expectations (Priority: 4/5): The discussion emphasizes using market data—Treasury yields, inflation expectations, stock prices, and nominal GDP forecasts—to infer where policy is drifting and whether demand is weakening. Level targeting and average inflation targeting (Priority: 5/5): Sumner advocates a stronger nominal framework, especially level targeting or at least a credible multi-year average inflation target, to anchor expectations and make up for past misses. Monetary policy versus fiscal policy (Priority: 4/5): He rejects the idea that monetary policy is powerless near zero rates, arguing that central banks can still do a lot more than fiscal policy and that political constraints are the real barrier. Global dollar spillovers and swap lines (Priority: 4/5): The podcast highlights how a strong dollar and dollar-denominated debt transmit U.S. monetary tightening globally, making Fed swap lines and international coordination important in a crisis. Emergency Fed tools and broader asset purchases (Priority: 4/5): Sumner suggests Congress could authorize the Fed, in emergencies, to buy a wider range of assets so it has enough firepower to hit its target and reassure markets.

Key Arguments: The coronavirus is primarily a supply shock, but the market’s fear response can reduce spending, velocity, and credit demand, turning it into a demand shock that monetary policy can offset. If the equilibrium interest rate falls and the Fed does not cut its policy rate, the stance of policy tightens automatically even if the nominal rate is unchanged. Interest rates alone do not measure ease or tightness; what matters is the policy rate relative to the equilibrium rate and the path of nominal spending. Market signals such as falling Treasury yields, lower inflation expectations, and stock declines provide indirect evidence that equilibrium rates and demand expectations have dropped. Nominal GDP forecasts and, ideally, a liquid NGDP futures market would give the Fed a better real-time guide than relying on lagging indicators or Phillips curve models. Level targeting is superior to ordinary inflation targeting because it forces the central bank to make up for past misses and raises credibility by committing to a path, not just a rate. Average inflation targeting over a multi-year horizon would be a useful crisis backup because it would improve expectations and reduce the chance of repeated undershooting. Fiscal policy is not the preferred response; monetary policy is more effective, less costly, and does not add to national debt, though political constraints may limit what the Fed is allowed to do. The Fed could seek emergency authority to buy a broader set of assets, including perhaps index funds, though conventional Treasury and MBS purchases may already be enough if policy is credible. Global crises create dollar shortages and debt burdens abroad, so Fed swap lines may again be necessary to stabilize foreign central banks and the world economy.

Data Points: S&P/stock market decline: over 10% - Opening framing of market turmoil linked to coronavirus fears 10-year Treasury yield: near 1.1% - Described as an all-time low during the market panic 10-year Treasury yield later in discussion: 1.3% - Host notes the yield had fallen to the lowest level on record at that point Recent market decline: about 6% over the past few days - Host describes the pace of market losses during the recording Hypermind NGDP forecast: 2.9% - Sumner cites the one-year nominal GDP forecast as somewhat low Fed inflation target: 2% - Used repeatedly as the benchmark for inflation targeting and level targeting discussion Fed rate hikes: 9 increases - Sumner argues the Fed tightened too much between 2015 and 2018 Potential average inflation target horizon: 5 years - Sumner proposes a five-year average inflation commitment as an emergency anchor Hypothetical price-level path: 10% higher in five years - Suggested example of a five-year level target after a downturn Housing construction decline in 2006-2008: fell in half over 27 months - Used as an example of a supply-side shock that later spilled into aggregate demand Long U.S. expansion: longest expansion in American history - Cited as evidence the Fed learned somewhat from 2019 and paid more attention to markets Fed asset purchases during QE: about $4 trillion - Compared with the much larger amount of eligible Treasury and MBS securities outstanding Eligible Treasury/MBS outstanding: around $32 trillion - Used to argue the Fed still has ample conventional assets to buy Japan/ECB balance sheet concern: over 100% of GDP for Japan - Referenced in the debate over whether central banks can run out of effective balance-sheet expansion

Pivotal Quotes:* "The coronavirus is basically a supply shock. However, what the markets are really worried about right now is a negative demand shock." — Scott Sumner: Core distinction in the episode between the virus itself and the broader financial/economic reaction "If the Fed does not reduce interest rates along with a fall in the equilibrium rate, then monetary policy will get unintentionally tighter." — Scott Sumner: Explains why holding nominal rates steady can be contractionary when r falls "The best we can do is some kind of level targeting of prices." — Scott Sumner: Summarizes his preferred policy response when ideal NGDP level targeting is not yet politically feasible

Implications: Listeners should expect central banks to cut rates, but the bigger issue is credibility: policy must keep nominal spending and expectations on track. A stronger nominal framework and better market-based guidance could reduce recession risk and spillovers abroad.