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  • Abiye Alamina

Coronavirus Fears Defies Rate Cuts

Today the Federal Reserve, the Central Bank of the United States, announced its intent to lower the benchmark interest rate, the Federal Funds Rate by 0.5% from its previous level to a range of 1.00-1.25%. This is typically stated in the media as a decision to cut interest rates by that amount. By setting a lower target for the Federal Funds Rate, which is the interest rate at which banks take out short term overnight loans from one another out of their excess reserves held with the Fed, the lower bank borrowing costs will spillover to the public in the form of lower bank lending rates.

A 0.5% rate cut is somewhat aggressive and was intended to signal the Fed's concern over the impact of the novel coronavirus - COVID-19, a now global pandemic problem, on the short to medium term outlook on economic performance in the country. Rate changes are usually preemptive as the Fed, seeking to fulfill its Congressional mandate of maintaining full employment and price stability, tries to steer the economy along the path of long run economic growth while avoiding economic swings in reaction to shocks to the economy.

Stocks reacted. Perhaps not as hoped, as a Bloomberg report released shortly after stated a 2.8% fall in the S&P 500 and an almost 3% drop in the Dow Jones Industrial Average. So rather than calm markets which have been on the retreat in the past week, markets appeared all the more spooked with no respite to be found in the Fed's aggressive policy which was carried out in emergency fashion - some two weeks earlier than when the FOMC would normally meet and make any such policy changes as deemed fit.

So what is going on here?

I have a few theories...

The first is the fact that an action taken by the monetary authority in emergency fashion simply communicates to investors that the COVID-19 looks to get a whole lot worse. Information coming out of the Centers for Disease and Control and Prevention (CDC) in the past week paints a bleak outlook with the expectation that the virus will very likely spread throughout the United States, and with fatalities now starting to increase in the US the announcement by the Fed simply stoked whatever embers of fear were present in markets.

With the virus having hit China, a major part of the global supply chain network, hard, US markets had remained somewhat tepid over the past month, the US economy being largely shielded by the relative size of its domestically driven production, but with the virus having spread and now a reality here in the US, investors are having to price in the implications of a potential fall in domestic output into stock market transactions. The Fed's announcement simply confirmed the uncertainty associated with how widespread COVID-19's impact would be and sent markets tumbling.

The second theory is perhaps part of what continues to drive the first. The concern that the action taken by the Fed is simply grasping at straws as it could possibly bring to fore another problem that has so far remained mute - inflation. Why? the COVID-19 problem is a supply side problem, what economists call an aggregate supply shock. Output is what is or will be affected - people might be unable to go to work out of fear, or because they are told not to, so as not to infected. Others who get infected will be quarantined, as would likely those who they are or have been in contact with, who test positive. So total output or Gross Domestic Product (GDP) will be expected to fall. This not only has the effect of making an economic recession more likely but also has a tendency to raise prices due to the resulting scarcity in output relative to existing levels of demand.

The problem then is that by cutting interest rates the Fed provides stimulus through reducing borrowing costs for spending to increase in the economy. This may help to stave off an economic recession but it does put even stronger upward pressure on prices - so it could trigger inflation, which is itself another monster. Concerns over looming inflation may actually be what is driving the market reaction to the Fed's rate cut.

A third theory is that the market simply believes that this is not a monetary problem. There is already a lot of liquidity within the banking system and cutting interest rates only serves to create an increase in that liquidity when there is really no strong need for increased spending in the economy. What the markets were hoping to hear from the Fed chair was perhaps some inside information to provide some measure of certainty associated with the spread of the virus. Unfortunately Jerome Powell had nothing more than we all have, so markets took a nosedive.

Monetary policy is not panacea. There are things that unfortunately monetary policy cannot solve and perhaps this is one of them especially because this is a problem on the supply side of economic activity while monetary policy only influences the demand side.


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