The Federal Reserve has never seen a hard stop to commerce like this.
A week ago, college basketball fans were looking forward to March Madness. Cities were planning St. Patrick’s Day parades. Las Vegas was booming.
Now, all that has been canceled.
Huge swathes of the economy simply came to a halt.
Right now, the Fed is like the pilot of an airplane that just had an engine cut out. The controls are still showing that the plane is at a good altitude and speed, but the pilot is realizing that it will crash if the course isn’t corrected. The indicators the Fed usually relies on for setting monetary policy, such as the unemployment rate, inflation, and gross domestic product, still show an economy near full health, but the underlying situation has changed entirely.
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Accordingly, Chairman Jerome Powell and the monetary policy committee faced historic uncertainty and risk ahead of their meeting scheduled for Tuesday and Wednesday in Washington. If they misread the situation, they could put the United States on a course toward “lost years” of high unemployment.
They responded by not waiting for Wednesday, and instead announced Sunday night a cut in their target interest rate to zero and $700 billion in government bond purchases.
Yet markets immediately plunged after the decision, suggesting that investors expected even more reassurance.
The problem facing the Fed is that it has to reassure investors that it will ensure the economy operates at full capacity in the long run, even as it shuts down out of necessity in the short term.
To be clear, the Fed cannot and should not try to fix the immediate problems caused by the pandemic, such as the cancellation of sports and the sudden unemployment of millions of restaurant workers. A rapid slowdown of commerce is economically beneficial, insofar as it helps halt the spread of the virus.
“There is nothing the Fed can do about supply-side shocks,” said David Beckworth, an economist at the Mercatus Center at George Mason University. “The Fed can’t make people well. It can’t change factory conditions in China. What it can do is deal with the spillover effects.”
Financial markets now suggest that investor fears could shape not just the short term, but also the long term, resulting in years of weak growth and higher unemployment.
There are already signs that, almost overnight, investors and consumers began expecting a massive slowdown in spending in the years ahead.
The most obvious is the massive stock market rout. Stocks fell by about a fifth in the last month. As bad as the pandemic is, it’s unlikely that it has cut future earnings of U.S. companies by a fifth. Instead, that decline probably represents fear that the economy won’t recover even after the virus threat has passed, that businesses won’t be able to hold out through the short term.
Another sign is the collapse in bond yields. The yield on 10-year Treasury securities fell by about a full percentage point in the past month, touching the lowest levels on record. Treasuries are considered a risk-free asset, as there is no possibility the government will stop paying interest. It’s as if investors collectively decided, all of a sudden, that there isn’t much worth risking long-term capital for and it would be better to hold safe assets instead.
Relatedly, expected inflation, as indicated by the difference between Treasury securities that are indexed to inflation and ones that are not, has fallen to the lowest level since 2009, during the worst of the global recession.
Those are warning signs. They are saying not just that the economy will shut down temporarily, a good thing if it helps curb coronavirus infections, but also that it might suffer for years afterward unnecessarily.
The question is whether the Fed can react to those warnings quickly enough.
Powell’s actions and comments Sunday suggest he is grappling with the problem. He said that the emergency rate cut was meant to “foster a more vigorous return to normal once the disruptions from the coronavirus abate.”
He also recommended that Congress use its power to tax and spend to protect businesses and individuals in the meantime. Otherwise healthy companies face the risk of failing to meet incoming bills during the pandemic lockdown and going bankrupt, making a temporary problem a permanent one.
In trying to act quickly, Powell is seeking to avoid the Fed’s mistakes of the past.
In 2008, as the subprime mortgage crisis unfolded, Fed Chairman Ben Bernanke and company had months to reckon with the aftershocks and still fell behind the curve.
After the notorious failure of the investment bank Lehman Brothers in September of that year, the Fed, just one day later, voted to keep its interest rate target steady at 2% because of the fear of inflation. “In retrospect, that decision was certainly a mistake,” Bernanke wrote in his memoir.
Then, the Fed failed to see what was happening: a massive decrease in expected spending. It failed to meet the corresponding market increase in the demand for money. In the months ahead, 6 million more people lost their jobs.
Powell and company now face a similar situation, but one in which the economic landscape is shifting far faster.
For his part, Powell suggested that he was prepared to change Fed policy more if necessary. “We think we have plenty of policy space left, plenty of power in our tools,” he said.
