Stocks opened higher on Monday, following a rare bit of good economic news amid deepening worries about a potential coronavirus pandemic. Central banks in the U.S. and Japan made public statements about their commitment to use monetary policy to offset the economic damage that could result from extensive business closures, illnesses, and deaths.
President Trump, as usual, is aggrieved about the Fed, though, feeling that it has not acted quickly and aggressively enough to cut interest rates:
Of course, if your first instinct when you see that tweet is to think that interest rates probably aren’t one of the most important policy issues when responding to an epidemic, you’re right.
“Using monetary policy to counteract the economic effects of the coronavirus outbreak would be a bit like using a hammer to try to unscrew a bolt,” wrote Justin Lahart in The Wall Street Journal last week. “But if a hammer is the only tool you have, you use it.”
Interest-rate cuts and other monetary-policy easing tools have been a key part of the global policy response to economic problems over the last two decades. Monetary policy has been important because one of the biggest problems in the global economy has been insufficient demand for products and services. Low interest rates make it cheaper for businesses and individuals to invest and consume and, therefore, boost aggregate demand.
The key question for figuring out how much central-bank action matters now is, “How much of the economic cost of the coronavirus is going to come from insufficient demand that could be boosted with easy money?”
In the short term, the answer is, “Very little.” The closure of factories and disruption of supply chains make it difficult for some companies to sell goods at any price, and lower interest rates won’t do anything to fix their troubles. In fact, with such a supply shock, you would usually worry that low interest rates would be inflationary — low rates would make people more eager to buy goods, but wouldn’t make it any easier to sell them, and so prices would just get bid up.
However, it’s clear from moves in the bond market over the last month that this is not what investors expect to happen. Inflation expectations have fallen sharply as the spread of the coronavirus has gotten more worrying. That means investors expect any inflationary effect from a supply shock to be more than offset by a deflationary demand shock: Consumers will be less inclined to buy things, either because they are staying home to avoid potential exposure to the virus or because their incomes have taken a hit. Individual incomes may fall either for specific reasons (you couldn’t work because your workplace was closed) or macroeconomic ones (economic weakness would hurt wage and job growth broadly).
In the short term, it may not be possible or advisable to offset much of this demand shock. If and when social-distancing measures are required in parts of the U.S., and people avoid crowded public places where they might spend money as part of those measures, low interest rates are unlikely to induce people to go to the mall, and we wouldn’t want them to anyway. The most important role the central banks play will be after the epidemic passes: We will want to ensure that the economy returns to normal as quickly as possible, and easy money will help get people spending as they were before the outbreak as quickly as possible. (As Jared Bernstein and Dean Baker note, there is also an important role here for fiscal policy; they recommend cash payments to individuals, similar to policies enacted in the last two recessions. But that’s a matter outside the hands of the Federal Reserve.)
That the banks will play their most important role in the aftermath of the epidemic is why statements like those from the Fed and the Bank of Japan are so important: The markets need reassurance about what the banks will do in the future. But investors also expect the banks to take action soon. Futures contracts on U.S. government bonds have moved in a way that shows that market participants expect the Federal Reserve to cut interest rates by half a point when the Federal Open Market Committee meets later this month. Market prices also reflect a possibility the Fed will be even more aggressive than that, either by cutting more sharply or by cutting earlier. And those are not expected to be the last rate cuts: Goldman Sachs expects a full point of rate cuts by June.
Since the coronavirus is a global problem, a coordinated global response from central banks would be desirable. But in a note to clients on Monday, Krishna Guha and Ernie Tedeschi of the investment-advisory firm Evercore ISI lay out some of the challenges that will face central banks as they try to coordinate. The pre-outbreak economic environment was weaker in Europe and Japan than in the U.S., and interest rates in Europe and Japan were already negative, which means central banks have less flexibility there to ease policy. The eurozone, as always, is politically fractured in a way that makes it harder for the European Central Bank to act and to ensure that governments implement fiscal policy — larger deficits — that would coordinate with monetary-policy ease.
This creates a challenge for the Fed: In order to provide the short-term easing that markets expect, it may have to act faster or more aggressively than the world’s other major central banks. The Evercore analysts expect the Fed will do so if necessary, though they think the Bank of Japan will be compelled to act promptly as Japan is especially economically exposed to the coronavirus owing to its proximity to China and the already significant domestic outbreak. The European Central Bank, they think, may act too slowly or too modestly. If the monetary-policy response around the world is too slow, that may create some drag on the U.S. economy even if our central bank is acting appropriately.
So Trump has a point about the Fed: A rate cut right now would be a good idea, which is why the markets expect one. But there is a reason stocks have risen only modestly on good monetary-policy news, offsetting just a small part of last week’s bloodbath: Interest rates will only do so much to help us here.
The primary government levers that will help determine economic outcomes are also the primary ones that will help determine health outcomes. If Trump wants the strongest economy possible as he seeks reelection, he should focus on the epidemic response itself. The smaller the health shock from the coronavirus is, the smaller the real economic shock will be, and the easier it will be for the Fed to help us recover from it.