- The coronavirus is sparking concerns of a major economic downturn.
- In response the Federal Reserve on Tuesday announced a 50 basis point interest rate cut.
- Many economists argue that the Fed shouldn't cut interest rates, because the nature of the coronavirus shock means that such a cut would do nothing to solve the issue or could even make it worse in the long run.
- But, the Fed's cut could also help boost investor and consumer confidence and help put the US economy back on the right footing.
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As a massive international public health response to the coronavirus is underway across the globe, economists agree that the coronavirus will produce some drag on global economic growth.
In fact, some observers are worried that the drag could drive the global economy into serious trouble. Even the typically measured former Federal Reserve Chair Janet Yellen warned that the virus could end up pushing the US economy into a recession if the illness is not contained.
In response to these worries, the Fed and Chair Jerome Powell on Tuesday took decisive action to try and mitigate the economic consequences by cutting the federal funds rate by 0.5 percentage points.
"The fundamentals of the US economy remain strong," the Fed said in its statement announcing the cut. "However, the coronavirus poses evolving risks to economic activity."
While the move was unexpected and represents the biggest one-time rate cut since the financial crisis, the response employs the Fed's main tool - interest rate changes - to help cushion the blow from the coronavirus. Despite the move, some economists have argued that the rate cut will do little to soften the impact of the coronavirus on the economy - and could even make it worse.
Either the Fed cut isn't going to do anything...
Even before the Fed's sudden move, some economists and market analysts already started to work through what a central bank response to a sustained outbreak in the US would look like. And there's a solid case that the Fed's cut may not really make a difference.
Put rather simply, interest rate cuts are generally a way to boost demand by making credit more readily accessible. This incentivizes businesses and consumers to borrow, spend, and invest more. That, in turn, stimulates the economy and gets the economy back on the level.
But, as Tom Porcelli at RBC Capital Markets wrote Thursday in a note to clients, a demand boost may not solve the coronavirus problem.
"The markets are calling for policy prescriptions that address demand shocks to solve what is a potential transitory supply shock driven by pandemic fears," Porcelli wrote.
Put another way, what good is a rate cut that helps consumers access funds when supply chains, factories, producers, and stores where they could spend those funds are all closed due to the virus? Or as Ryan Avent, an author and economics columnist for the Economist, wrote in a recent newsletter:
"But where we generally know how to deal with demand-induced deflation-by throwing a lot of fiscal and monetary stimulus at the problem-we've got much less of a handle on what to do when it's a supply problem. It doesn't matter how much newly printed money you put in people's pockets if there are no stores open and no trucks to supply them anyway."
In effect, it wouldn't matter what the Fed does, because the tools it has to help the economy aren't made to deal with a coronavirus-type shock. Jim Bianco, of Bianco Research, argued that this left the central bank with few options but to ride out the virus.
"Clearly a rate cut will do little to mitigate a global supply chain disruption due to the coronavirus," Bianco wrote in a note to clients. "In this sense, the Fed is at the mercy of the coronavirus or a potential vaccine."
Or as Scott Minerd, the chief investment officer for Guggenheim Partners, put it: "The Fed is fairly impotent in this environment."
... or it could make things worse
While the Fed's rate cut may ultimately prove fruitless in protecting against a supply-side shock like the coronavirus, there is also a chance that the rate cut could actually do more harm than good.
For one thing, cutting rates during a stock market sell-off and a crisis of confidence could send a signal to investors and consumers that things are going to get worse. As Minerd told Bloomberg TV, the Fed would want to "try to avoid sending a signal that stirs further fears" in the event of a rate cut.
And as Bloomberg's Joe Wiesenthal pointed out in a newsletter on Thursday, there's actually a situation in which the coronavirus is inflationary and actually contribute to upward price pressures.
In this instance demand bounces back fairly quickly as the virus is contained in the next few months and the pent up economic activity is released. But, supply chains take longer to restart since restarting the manufacturing of goods is a bit more complicated than just getting people back to work. Thus the pent up demand is met with a lack of supply and suddenly prices start to creep higher.
By cutting rates, the Fed could think it's helping but instead the cut would be adding demand and risk running inflation even higher.
To be fair, inflation has remained persistently below the Fed's 2% target since the financial crisis and the duration of those inflationary pressures could be temporary but it's worth considering before the central bank makes such a move.
... or it could help ease people's worries
While an interest-rate cut may not have much direct effect in lifting the US economy - or in fact end up making things worse - there is also an argument to be made that the psychological boost Powell and the Fed could give the economy may be just the right medicine to combat the coronavirus' economic effects.
While the debate over whether the stock market is or is not the economy rages on, stocks typically have a strong correlation with measures of consumer and business confidence. By cutting rates, the Fed is trying to mitigate the stock sell-off and potentially prevent a panic among consumers and businesses.
Just on Tuesday stocks rebounded significantly after the announcement of the rate cut and while the gains were pared somewhat, it's clear that investors took some heart in the decision.
So the rate cut could be effective at reassuring investors and businesses that the Fed is prepared to help get the economy back on its feet once the virus is contained.
Put another way, the Fed is trying to signal to Americans that it's still a good time to apply for that mortgage, buy that washing machine, or hire that new worker.
This is an opinion column. The thoughts expressed are those of the author(s).