The outbreak of the novel coronavirus (Covid-19) has thrown markets into turmoil. With the coronavirus now threatening to disrupt the U.S. economy, the Federal Reserve has stepped into the fray.
Contagion spreads
The economic disruption from the coronavirus has already been substantial. Fears about the coronavirus in China led to a month-long virtual shutdown of economic activity across much of the world’s second-largest economy. While U.S. capital markets shrugged off these developments for a while, mounting fears of a widespread domestic outbreak have begun to weigh heavily on stocks. On Feb. 28, analysts at Morgan Stanley (MS, Financial) opined that the specter of domestic economic disruption would compel the Fed to act:
“We see a rising likelihood of extended disruption as the virus spreads to new geographies. In that scenario there are production disruptions, rising unemployment, and a hit to consumption that are too much for the Fed to ignore.”
As the nation’s central bank, the Fed’s mandate makes it responsible for setting monetary policy and moderating the business cycle. However, that mandate seems to have morphed over the past couple of years.
A dose of monetary medicine
In early 2019, Jerome Powell, the Chairman of the Fed, buckled under political pressure from President Donald Trump. Fearing an economic slowdown, Trump managed to get the Fed to abandon its traditional hawkish bull-market monetary stance. Ever since, the Fed has adopted a dovish stance. Indeed, the central bank has seemed more concerned with buoying capital markets than with managing the business cycle, which has resulted in a veritable bubble in everything.
The coronavirus has at last spooked U.S. investors, sending stocks tumbling late last week. True to form, the Fed reacted to the recent plunge on Mar. 3, announcing a sharp cut to interest rates that lowers the key federal fund rates by half a percentage point to a range of 1% to 1.25%.
More treatments likely
While the Fed’s response has been aggressive, more action has been demanded from the central bank. President Trump took to Twitter in the wake of the rate cut announcement, demanding still more monetary loosening:
“The Federal Reserve is cutting [sic] but must further ease and, most importantly, come into line with other countries/competitors. We are not playing on a level field. Not fair to USA. It is finally time for the Federal Reserve to LEAD. More easing and cutting!”
The market evidently expects the Fed to oblige the President, as it has done frequently in the recent past. The futures market has already priced in further substantial cuts in March alone, as macro analyst Jim Bianco observed on March 3:
“The Fed might not be done this month. The fed funds futures market is placing the probability of another cut at the March 18 FOMC meeting at 114%. In other words, they are pricing in a 100% probability of another 25 bps cut and a 14% probability of a 50 bps cut in two weeks.”
Not an antidote
If the U.S. economy slows due to fears of the coronavirus, the Fed will have little power to alter the situation. Cutting interest rates may help to shore up capital markets and support some economic activity, but it is no panacea.
The Fed cannot do anything to thwart the spread of the coronavirus, nor can it alleviate people’s fears of the disease through monetary policy tools. It is a public health crisis first and foremost, yet the Trump administration appears to be more interested in the coronavirus’s impact on the stock market than it is on actually confronting the outbreak. As the Washington Post observed on Feb. 28, the administration’s proposals, including emergency tax cuts and looser monetary policy, cannot fix the underlying problem:
“The proposals would do little to stop the virus’s spread, but would aim to arrest economic fears.”
Weakening immunity
The Fed has already been playing a dangerous game by propping up capital markets through rate cuts and liquidity injections. This latest rate cut reduces the central bank’s financial firepower still further. In the event of another rate cut this month, as is now expected, the Fed will be left with few tools to combat the next recession or economic downturn.
By fixating on the short-term contagion, the Fed is exposing the economy, and capital markets, to a much more painful disease. Investors should move with extreme care.
Disclosure: No positions.
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