As the Federal Reserve weighs a response to the spread of the coronavirus, it faces a novel challenge — there is not much evidence on whether monetary policy is the right response to a potential pandemic. So far, policymakers have only signalled that they are “closely monitoring” the virus. But investors increased bets on an imminent US interest rate cut on Thursday, pushing the perceived likelihood of a 25 basis point cut at the Fed’s March meeting close to 96 per cent, according to the CME Group.The Fed may be running out of time for monitoring, even as it is not completely clear what it might do. “If the Fed cuts by 25bp, I don’t think it would make much of a difference,” said Olivier Blanchard, former chief economist at the IMF. Now at the Peterson Institute for International Economics, Mr Blanchard argues that a pandemic represents a “supply shock” — it suddenly takes workers out of production and prevents products from getting to shelves and factory floors.
They’re going to zero very fast . . . It’s the message that we are there to do whatever it takes
Monetary policy stimulates demand for goods, spurring businesses and homebuyers to borrow, and investors to take risks. But it is difficult to encourage a business owner who cannot find parts and whose employees are in quarantine. “Cuts in rates,” said Mr Blanchard, “would be symbolic but not useful.” In 2005, in response to a request from Congress about the consequences of an avian flu pandemic, a study from the non-partisan Congressional Budget Office focused on disruptions to supply. Not just illness but school closings would keep workers home in a pandemic, it found. As transport networks broke down, even domestic supply chains would be severed. Anil Kashyap, professor at the University of Chicago’s Booth School of Business, said monetary policymakers had yet to decide whether the virus represented a supply or a demand shock. “I believe you can find lots of central bankers saying that monetary policy is probably not the best-suited tool,” he said. Central bankers like data, and there is just not a lot of data on pandemics. The CBO’s study found only three precedents, and divided them into two scenarios. In a mild scenario, similar to the flu pandemics of 1957 and 1968, 75m people are infected in the US and 100,000 die. According to the CBO, there would be a single-year drop in growth of 1 percentage point, and the outbreak probably would not cause a recession. In the severe scenario, similar to the Spanish flu outbreak of 1918, 90m become sick and 2m die. Activity would fall by 10 per cent in most industries, and by 67 per cent in transport and 80 per cent in hospitality. This would almost certainly create a recession, with a 4.25 percentage point drop in overall economic growth for the year. If this happens, the Fed will not have the luxury of declining to deal with a supply shock, and will have to use its tools as best it can. Here it faces yet another problem, one that Fed chairman Jay Powell has called “the pre-eminent monetary policy challenge of our time”. With policy rates already so low, there is not much room to move. “They’re going to zero very fast,” said Anwiti Bahaguna, senior portfolio manager at Columbia Threadneedle Investments. “They’ll surprise to the downside.” Ms Bahaguna said any kind of rapid action would make a difference and that, above all, it is the Fed’s job to show conviction. “It’s the message,” she said, “that we are there to do whatever it takes.”
Complicating matters is that the Fed is not yet finished with a year-long review of how it communicates with the financial markets about monetary policy and what a response to a hypothetical downturn should look like.Over the course of its review, the US central bank has hinted that if conditions seriously deteriorate and a downturn becomes a recession, it is prepared to move quickly to non-traditional tools. At an event in New York last week, Fed governor Lael Brainard, in a discussion of large-scale asset purchases and “forward guidance” on policy, said uncertainty and concern over the risk of inflation had slowed the response after the global financial crisis, and that delays had made the new tools less effective.“These costs and risks did not materialise or proved manageable,” she said, “and I expect these tools to be deployed more forcefully and readily in the future.”Her comments echoed conclusions from the Fed’s September meeting when, according to the minutes, several policymakers noted that “experience with forward guidance and balance-sheet policies would likely allow the [Federal Open Market Committee] to deploy these tools earlier and more aggressively in the event they were needed”. Michael Feroli, chief US economist at JPMorgan, said that even as the Fed completes its review, the coronavirus may be the first real test of the bank’s resolve on using non-conventional tools — particularly if the virus spreads within the US.“I think the Fed will do what they have to do with policy as the situation evolves, while keeping the framework review progressing on a parallel track,” he added. “I think the Fed has shown in the past that they can walk and chew gum.”Read more about the coronavirus impactSubscribers can use myFT to follow the latest ‘coronavirus’ coverage