In normal times, this highway in Wuhan, China, is jammed with cars, buses, scooters and trucks. When people can’t go to work, the goods and services they normally produce can’t be supplied to a global market. The Fed can’t do a lot about that.
Financial markets have stepped up their expectations for interest rate cuts in recent days as fears of a global pandemic finally rocked the heretofore ebullient U.S. stock market.
Federal funds futures are putting the odds of at least one 25-basis-point rate cut by June at 81%, compared with 48% a week ago, according to CME FedWatch tool. The probability of at least two rate cuts by December has risen to 78%. (As stocks DJIA, +0.67% SPX, +0.68% GDOW, -2.22% go down, the probability of a rate cut goes up.)
‘[T]he only reason you would cut rates now is if you’re the central bank of the S&P 500.’
Short of an accurate assessment of the full scope of the coronavirus — whether or not it becomes a true pandemic — it’s impossible to determine the economic impact or the Fed’s response.
What is possible is to examine the known economic impact from the coronavirus-borne disease, identified as COVID-19, in the context of the Fed’s available tools to address economic weakness.
To date, at least as far as the U.S. is concerned, the main impact of the disease has been on aggregate supply. The Fed’s interest-rate tool is designed to address aggregate demand. So the cause and the cure would appear, on the surface, to be incompatible.
The Fed can’t produce parts for automobile manufacturers across the globe that are dependent on intermediate-goods imports from China. It can’t reopen factories in Hubei Province, the epicenter of the coronavirus outbreak. It can’t provide needed factory workers for plants in locked-down areas of China. And it can’t create alternate supply chains as a substitute for China’s role as manufacturer to the world.
The U.S. consumer has been resilient. It’s Chinese consumers who have curtailed their spending because of quarantines, shuttered stores, restricted travel or fears of going out to public places to shop. Photos of empty streets convey the devastating impact the virus has already had on China’s economy.
The retrenchment in Chinese spending in turn hurts U.S. producers as the Chinese have become dependable consumers. China is the largest market for automobiles, for example. Chinese tourists travel widely and travel well, buying luxury goods from New York to Paris to Tokyo.
So yes, U.S. businesses will be affected. Many, including Apple AAPL, +1.96% , Starbucks SBUX, +0.11% and McDonald’s MCD, +0.11% , have closed stores in China. The travel industry is hurting. Airlines have canceled flights to and from China and other affected countries, with numbers seeming to increase by the day. The hospitality industry — hotels, restaurants, etc. — struggles as tourism declines. Global trade is another casualty.
But lowering U.S. rates won’t stimulate Chinese demand. The demand-side weakness — reduced U.S. exports to China, exacerbated by a strong dollar BUXX, +0.20% and reduced spending in the U.S. by Chinese tourists — is coming from abroad and, as such, will not be responsive to a reduction in U.S. interest rates.
Nor will the decline in U.S. production due to a lack of intermediate inputs and shrinking overseas purchases be reversed by lower rates. Businesses aren’t going to invest and produce more if fewer people are buying.
That doesn’t mean the Fed won’t cut rates if the U.S. economy shows signs of more than temporary weakness from the effects of the virus. When an economy is only growing at 2%, it doesn’t take much of an external shock to put it in a precarious position and trigger recession fears.
Goldman Sachs economists raised their projection for the drag on first-quarter gross domestic product from the coronavirus to 0.8 percentage point, lowering their real GDP forecast to 1.2%. Much of the drag should be recouped as the year progresses, according to Goldman.
A Fed rate cut is not the prescribed antidote for a negative supply shock. In fact, “the only reason you would cut rates now is if you’re the central bank of the S&P 500,” said Jim Bianco, president of Bianco Research, using a moniker the Fed abhors.
The Fed could choose to lower interest rates to stimulate domestic demand in the hopes of offsetting some of the weakness abroad. Goosing demand for a limited supply tends to raise prices — which might help the Fed hit its 2% inflation target.
The Centers for Disease Control warned on Tuesday that the coronavirus epidemic would inevitably spread to the United States but did not estimate to what extent. Should it infiltrate the U.S. to any significant degree, it would cause U.S. consumers to hunker down. Any significant pullback in the stock market could result in a reverse wealth effect, wherein consumers feel poorer and spend less.
The Fed may be ill-equipped to deal with a global supply shock, but there exists a better reason for the Fed to consider lowering interest rates, now that the yield curve has inverted again. The yield on the 10-year Treasury note TMUBMUSD10Y, -1.48% hit an all-time low on Tuesday of 1.31%, pushing it below the yield on both the federal funds rate (1.5%-1.75%) and the 3-month Treasury rate TMUBMUSD03M, +1.37% (1.53%).
The yield curve was inverted from May to October of last year before righting itself with the help of the Fed’s three rate cuts. If the inversion persists, and deepens, especially if the stock market rebounds from its four-day rout, that would be a valid sign that the Fed needs to act, coronavirus or no coronavirus.