The coronavirus crisis and lockdown greatly disrupted economic activity in the United States. The Federal Reserve expected a deep recession and quick recovery. While those predictions proved correct, Fed Chair Jerome Powell remains pessimistic and has called on Congress for additional fiscal stimulus.
Is fiscal assistance necessary or could the Fed enhance the recovery with monetary policy?
Disruption to Production
Economic disruptions or “shocks” generally come in two types: Disruptions to productive capacity affect the supply of goods in the economy, while disruptions to spending affect the demand. The coronavirus outbreak and ensuing lockdown were primary supply-side shocks since people were unable to work and businesses unable to produce.
The Fed has limited ability to respond to supply shocks since it can only influence money and spending and does not directly affect production. In the current crisis, the disruptions were expected to be temporary and likely followed by a speedy recovery. The Fed had no ability to prevent the economic downturn, but it could provide an accommodative monetary policy to hasten the recovery.
As Powell described in an interview on March 26th: “This is a situation where people are being asked to step back from economic activity, close their businesses, stay home from work. So, in principle, if we get the virus spread under control fairly quickly, then economic activity can resume. And we want to make that rebound as vigorous as possible.”
The Fed’s economic forecasts seemed consistent with Powell’s prediction that the virus would create a short-lived supply disruption. The sharp second quarter decline in gross domestic product (GDP) of 32.9% was the worst in the history of the United States, but economic forecasters expected a strong recovery in the second half of the year.
In their June meeting, the Federal Open Market Committee (FOMC), which determines the stance of monetary policy, forecasted that GDP would be down only 6.5% by the end of 2020, a bad contraction to be sure, but far better than the dismal second quarter. The rate of unemployment, which peaked at 14.7% in April, was expected to fall to 9.6% by December.
The latest numbers are even better. The rate of unemployment was down to 8.4% in August, already ahead of the Fed’s end-of-year forecast. The FOMC now predicts that unemployment will fall to 7.6% by the end of 2020, nearing the long-run average around 6%. For GDP, the FOMC predicts a rate of -3.7% in 2020, an improvement of 2.8% from their previous forecast.
Despite these positive revisions, however, Powell in his recent press conference took a very negative tone. He said that “more fiscal support is likely to be needed.” He warned that “overall activity remains well below its level before the pandemic and the path ahead remains highly uncertain.” These comments seem to contradict the Fed’s previous characterization of the downturn as a short-lived supply shock.
Lockdown vs. Livelihood
What should consumers and investors make of the Fed’s mixed messages? The FOMC is itself responding to conflicting trends in the economy. The most recent data, for example, show positive growth in home sales and durable goods orders, while declines in initial unemployment benefit claims appear to have stalled.
These outcomes, however, appear to be attributable to the same supply shocks that caused the initial declines: virus fears and government lockdowns that prevent people from working. As Robert Hughes describes, “Government-imposed restrictions intended to slow the spread of Covid-19 continue to wreak havoc on the economy and the labor market.”
The Fed’s initial forecast of a short-lived supply shock is supported by recent evidence. Such shocks will dissipate as the virus wanes and states relax their restrictions on business activities. These supply shocks cannot be prevented with monetary policy, nor by fiscal stimulus as mentioned by Chair Powell.
Targeted fiscal policies benefit particular groups of citizens, such as the relief programs for out-of-work Americans. But such policies require Congress to decide who receives funds and who does not, which is less efficient than distributing funds through monetary policy and the financial system. Fiscal policy is not effective at influencing aggregate demand. It is not an effective complement to monetary policy by the Fed.
As cities and states ease their lockdowns and restrictions, the Fed should continue to support the recovery with accommodative monetary policy. As Powell described, “A full economic recovery is unlikely until people are confident that it is safe to reengage in a broad range of activities.”