There is a growing buzz in the media that the Federal Reserve and other central banks should provide support due to any slowdown that accompanies the coronavirus. Slow or fast, the virus will spread. At the current rate of contagion, it appears that the spread is occurring relatively quickly, at least in terms of span of geography.
Widespread disruption is on the horizon. We have already seen Apple’s supply chains disrupted. Difficulties are mounting in China. Our coming to terms with the nature of this spread is leading many to panic. Unfortunately, during a panic, our cognitive capacities may not do the best job of integrating all pertinent facts into decision making.
This problem seems to hold for those formulating monetary policy at present. I will review macroeconomic and financial markets through the lens of supply and demand to the elaborate mechanics of disruption and the relevant options for monetary policy.
Monetary Policy Is Not Suited to Offset Negative Aggregate Supply Shocks
As a general rule, the Fed should not attempt to remedy a negative aggregate supply shock with monetary policy. Monetary policy is useful in offsetting slowdowns that occur due to negative aggregate demand shocks. Falls in the value of total expenditures that occur due to either an increase in demand to hold money or a decrease in the quantity of money lead to temporary macroeconomic disruption. The value of total expenditures fails to match the total value of goods expected to be sold across a given period. Either a fall in the average level of prices or an increase in the quantity of money can offset this discrepancy.
The case is different for an autonomous fall in aggregate supply. A negative supply shock entails a fall in the level of output that can be supported by a given capital structure. This may occur, as in the present case, due to prolonged disruption of supply chains. Currently, the volume of trade is falling and is likely to continue falling as nations take precautions to slow the spread of the coronavirus.
All else equal, any fall in real GDP that we experience will be a textbook real business cycle, with the aggregate supply curve shifting left. The fall in the availability of goods will lead to a general increase in prices. Since expectations seem to be moving quickly, prices may move ahead of the fall in supply as individuals rush to the store to stock up on goods. An increase in the quantity of money would only exacerbate this problem.
Conversely, attempts to offset any increase in inflation due to the fall in income would only lead to further detriment. To maintain a 2 percent rate of inflation in the face of a negative aggregate supply shock, the Federal Reserve would have to slow the rate of growth of the stock of base money in circulation. This is a fundamental problem with price level and inflation targeting.
To maintain a constant rate of inflation, a negative aggregate supply shock must be offset by a reduction in aggregate demand. I doubt this will be the policy of choice, but mindless pursuit of the 2 percent inflation target could lead to such an outcome. It is unclear what policy makers will view as the optimal path for monetary policy.
Saying One Thing and Meaning Another
There also are difficulties in interpreting financial conditions and identifying distortions created by Federal Reserve intervention in short-term lending markets. The situation is more complicated in financial markets. A negative aggregate supply shock could lead to a negative aggregate demand shock if the fall in business activity degrades the solvency of borrowers, leaving many unable to repay loans or acquire revolving credit lines on which their businesses typically depend. Or, reflecting changes in underlying conditions, demand for credit at existing rates may fall as trade slows.
In this case, falling rates are a symptom of falling demand for credit in light of lower growth. Credit supply constraints are causing difficulties for business in places affected by the coronavirus. An increase in such difficulties could impact capital structure for years to come, so it is not clear we can discount the significance of this interpretation. In either case, it is difficulties arising in financial markets that are likely behind Powell’s forward guidance promising potential support from the Federal Reserve. Fed officials would like to avoid structural damage from an epidemic.
But what is the nature of support from the Federal Reserve? The apparent intervention by the Federal Reserve is actually alleviating the difficulties created by Fed policy.
Let’s suppose that the current fall in rates represents a rational response to a fall in profitable investment opportunities. In that case, lowering the federal funds rate target would not represent artificial support, but equilibration. What is preventing credit markets from reaching equilibrium? The rate paid on excess reserves is acting as a price floor. If I am correct, the yield curve inversion is an artifact of Federal Reserve intervention in short-term lending markets.
Short-term rates likely would also fall, except that the rate paid on excess reserves sets a price floor that can only be adjusted by Federal Reserve policy. The rate paid on excess reserves is the relevant alternative to holding short-term financial instruments. Thus, the effective federal funds rate hovers around the true risk-free rate: the rate paid on excess reserves. In the face of economic decline, long-term rates are falling while short-term rates remain elevated.
A decade ago, I might have characterized this as a rush to liquidity. But this does not appear to be the case with the current yield curve inversion. Long-term rates have fallen below short-term rates on expectation of a negative aggregate supply shock.
For Powell to lower the federal funds rate target and the rate paid on excess reserves would not artificially stimulate investment but, rather, prevent the rate paid on excess reserves from acting as an interest rate floor. As with any effective price control, when conditions governing supply and demand schedules change, that price control can exert a disequilibrating effect.
The nature of monetary conditions may not be clear, but two facts are. First, the Federal Reserve should not respond to a negative aggregate supply shock by boosting aggregate demand. However, if the situation devolves into a credit crisis, then the standard tools used to stabilize aggregate demand might be appropriate. Second, the interest rate paid on excess reserves is acting as an interest rate floor and is likely playing a significant role in the current yield curve inversion.
A lowering of the federal funds target, in this case, would allow credit markets to generate a mix of investments that would predominate absent monetary intervention.
The Federal Reserve is likely trying to balance its support for federal borrowing with this current supply-side disruption. The true difficulty lies in balancing these emerging difficulties with the responsibility for federal borrowing for which the Federal Reserve has assumed responsibility in the last decade.