Investors over the past few days have priced in three 25 basis-point cuts in the federal funds rate by the end of the year, with the first cut implied by the markets coming in June. This is somewhat misguided, given the nature of the global public health emergency that is the catalyst for the change in market expectations around monetary policy.
Fed action is a necessary, but not sufficient, policy response to the potential risks in the economy.
Fed action is a necessary, but not sufficient, policy response to the potential risks in the economy.
Given the scale and scope of the public health emergency — the Centers for Disease Control and Prevention said on Tuesday that it is preparing for a potential pandemic — any adverse economic impact to the U.S. economy requires a policy mix of fiscal and monetary action.
In fact, the unusual and exigent circumstance of the virus spreading to the United States–resulting in a reduction in labor supply and spending for a temporary but extended time–will require a period of policy creativity aimed at Main Street to cushion the economic blow.
The primary policy option preferred by financial markets is a cut in the federal funds rate. This would temporarily boost financial conditions and asset markets. But in this most unusual case, the Federal Reserve would most likely issue a rate cut with guidance that it will take it back once the crisis passes. It is highly uncertain under such circumstances that the rate cut will boost financial conditions in such a fashion that it will reverse recent losses across asset classes.
Moreover, a single 25-basis-point rate cut would take several months to work its way through to the real economy, and would most likely be reversed before its economic impact becomes beneficial. It would also harm the central bank’s credibility in the process. For these reasons, we think that in the near term there will be no rate cut from the Fed.
The fiscal channel offers a more promising way to address legitimate public health concerns and to lay the groundwork for much more robust action should it be required.
Supplemental U.S. spending on the outbreak
We are encouraged that the current administration has asked Congress for $2.5 billion ($1.5 billion in new spending) in a special supplemental funding plan to address the front edge of the crisis. Yet, this is likely to be just a down payment on a larger outlay that may be required over the next several months.
The shadow of monetary and fiscal operations from the financial crisis a decade ago hangs heavy in the air. Whatever happens over in the near term, it is critical that any aid be aimed at Main Street, and not just Wall Street.
At a minimum, that means that inside the federal agencies that offer assistance for trade, small and medium-size enterprises need to be mobilized to use current appropriations and any special supplemental funds to offer bridge financing. It is the responsibility of the fiscal authority to drive this policy response. Leadership and policy creativity will be required to navigate the expanding crisis.
In the unusual circumstance that there is a severe economic disruption – like the effective quarantine of large, economically important population centers in the United States — the small and medium-size enterprises that make up Main Street and the real economy will need bridge financing to mitigate the crisis.
It is important to note that the large active multinational firms will be able to tap lines of liquidity offered by broad and deep American capital markets. But small and medium-size enterprises do not have such a luxury and they should be the target of any federal efforts to mitigate disruptions in access to labor, demand, supplies and revenues. In particular, trade finance through the U.S. Treasury will be key to mitigating the crisis and jump-starting the rebound in its aftermath.
In the unusual circumstance that there is a severe economic disruption – like the effective quarantine of large, economically important population centers in the United States — the small and medium-size enterprises that make up Main Street and the real economy will need bridge financing to mitigate the crisis. It’s here that policymakers may need to get creative.
One could easily envision Congress and the administration creating a temporary lending facility to provide liquidity to these enterprises in much the same way the Federal Reserve did to the banks and large companies such as General Motors during the financial crisis. If the political polarization in Washington results in nothing getting done, the Fed could easily do the same.
Without a doubt, the Fed will be part of a policy matrix that deals with the potential crisis. But the fiscal authority should take the lead in combating the crisis.
