Coronavirus frightened markets, not the Fed

Published on Thursday, 27 February 2020 19:35
Written by Bill Dudley

The U.S. equity market finally is taking notice of the coronavirus, which now is spreading from China to other countries and increasing the risk of a shock that could cause a U.S. recession.

So what are the implications for the U.S. economy and the Federal Reserve? Obviously, that is a difficult question to answer because it’s impossible to anticipate what comes next.

That said, policymakers need to consider the potential impact, which as I see it has two distinct elements.

The first is the impact on economic activity where cases are most prevalent, such as China, Singapore, South Korea and, most recently, northern Italy. Here there are consequences for both supply and demand. Output is falling as factories close to keep people from congregating and spreading the virus. Demand is falling as people stay home. That means a drop in leisure activity and retail sales, especially for items for which purchases can be deferred, such as motor vehicles.

The second is the impact on economic activity elsewhere. Here there also are demand and supply effects. Travel from the affected areas is being sharply limited to prevent the further spread of the virus. This hurts hotels and airlines. Production will decline as disruption to global supply chains leads to spot shortages of critical inputs; you can’t build a car unless you have all of the parts.

In thinking about how powerful these impacts could be, one might assess the effect on economic activity from the direct impacts versus the indirect ones because of the effect on public sentiment.

The direct impact depends on the number of people infected, the mortality rate and the breadth of the nations where outbreaks occur.

The indirect impact is how people react. For example, will travelers refuse to go to Asia? That depends, of course, on the severity of the epidemic, but it also depends on people’s risk aversion.

This effect is perhaps the most difficult to judge. Modern experiences with epidemics are limited. Moreover, every experience is different in terms of prevalence and virulence. I suspect that 100,000 cases in one city probably would have much less impact than 100,000 cases spread widely around the world.

So how should the Fed respond given the high degree of uncertainty?

Most likely, the Fed will wait a while longer before considering interest-rate cuts. After all, the harm to the U.S. economy remains mostly speculative at this stage.

But it won’t take much more bad news for Fed officials to signal that they are prepared to act. More economic data about Chinese economic growth, imports and exports, and the impact on U.S. manufacturing eventually will become available. This will be important in shaping Fed policy makers’ views.

The greatest risk to the record U.S. economic expansion is an external shock that the Fed can’t offset because it responds either too late or without enough force. This risk is rising.

Fed officials recognize that it doesn’t take a particularly big shock to push the U.S. into recession. When the dynamic of the economy turns negative, the feedback loop from a drop in demand on production, employment, income and sentiment can be quite powerful. This may be particularly relevant right now; the economy doesn’t have much forward momentum and sentiment probably is fragile in the face of a growing risk of a global pandemic.

If the situation stays roughly the same or deteriorates further, I would expect Fed officials to take note of the risks in their next Federal Open Market Committee policy statement and for Chair Jerome Powell to make it clear in his press conference that the Fed is alert and prepared to respond forcefully should that prove necessary.

This view is consistent with what is priced into the federal funds futures market; the market anticipates about 60 basis points, or 0.60%, of rate cuts during the next year. But expectations also indicate that the Fed wants to wait and gather more information. For now, that seems like the right view.

Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies.

Posted in New Britain Herald, Columns on Thursday, 27 February 2020 19:35. Updated: Thursday, 27 February 2020 19:38.