- The Federal Reserve's emergency rate cut coupled with the impact of coronavirus on the US economy could lead to stagflation, Nancy Davis of Quadratic Capital Management told Markets Insider.
- Stagflation is when an economy is not growing fast enough to outpace price increases.
- The US economy is largely supported by the consumer, meaning that higher prices in the form of inflationary pressure that is not growth related "could be really devastating," said Davis.
- Read more on Business Insider.
The Federal Reserve on Tuesday handed down an emergency interest rate cut to combat any slowdown the US economy could see from the spreading coronavirus outbreak.
The 50-basis-point cut was an unexpected and rare move showing that the central bank considers a coronavirus outbreak a threat to the US economy.
But the lower interest rates coupled with coronavirus could do more harm than good and lead the US economy to a toxic situation where prices surge but growth slows, Nancy Davis, managing partner and chief investment officer of Quadratic Capital Management, told Markets Insider in an interview.
"The biggest risk right now is the stagflationary environment where we have these higher prices coupled with lower growth," Davis said.
Stagflation - an economic term that means inflation overtakes gross domestic product growth - could occur as the virus spreads and companies in the US increasingly cut down on business travel, cancel conferences, and tell workers to stay at home, she said.
Supply chains of US companies have also been disrupted because of a government shutdown of factories in China, where the virus originated. In February, China's manufacturing purchasing managers index, which measures factory activity, fell into a contraction because of the shutdown. US growth is looking more bleak amid the coronavirus outbreak as well. At the end of February, Goldman Sachs lowered its US GDP forecast to 1.2% from already-low 1.4% for the first quarter due to production cuts and supply chain disruptions stemming from coronavirus.
Bracing for stagflation
That could cause a supply shock that would send prices higher, especially as people "are still going to want to buy things" even if the virus' spread means people stay in more or work from home, according to Davis.
The US economy is largely supported by the consumer, meaning that higher prices in the form of inflationary pressure that is not growth related "could be really devastating," Davis said.
There have been some signs of this kind of economic environment in China, where the virus originated. Prices have skyrocketed amid government shutdowns, according to Zhiwei Ren, managing director of Penn Mutual Asset Management. But, Ren thinks that the situation is likely to correct itself when the spread of the virus slows and production returns to normal.
"There is some stagflation going on in China, but it's very transitory," Ren told Markets Insider in an interview. "When things go back to normal, the supply will come back online and prices will come down."
Further, in the US, the Federal Reserve has consistently fallen short of its inflation target of 2%, meaning that a slight uptick wouldn't be terribly damaging to the economy. And, after the emergency cut on Tuesday, interest rates actually moved even lower.
The problem with low rates
Still, while stagflation may be an "apocalyptic" outcome, it's not a scenario with zero probability of occurring, according to Lisa Shalett, chief investment officer of Morgan Stanley. And, low interest rates cause other problems such as massive misallocation of capital, which can cause asset bubbles, she said.
"We talk about the fact that there's no inflation in the economy, but if you look at the inflation in financial assets, it's been profound," she said. Inflation in prices in the US has been low over the last decade, while the stock market has enjoyed a compound annual growth rate over 14% in the same time period.
"Our view is that low interest rates create a massive misallocation of capital where free money or very cheap money causes people to invest in a lot of stupid things that ultimately don't succeed," she said.
Was the emergency rate cut the right call?
There are other unknowns of the threat that coronavirus and the illness it causes, COVID-19, pose to the US economy.
If people decide out of fear that they should self-quarantine and stop going out to restaurants and sporting events, using public transportation, and shopping, it will freeze the economy and push it into a recession, Shalett said.
If a recession does occur, the Fed is in a precarious position without much ammunition left. After Tuesday's emergency cut, the Fed funds rate is between 1% and 1.25%, meaning that it doesn't have much lower to go.
"In many ways the Fed may have shot bullets at the absolute wrong time and made a massive policy mistake," Shalett said. "There's even odds that that's the case."