In the days when the coronavirus was just beginning to dominate the news, analyses of its economic impact emphasized that its spread counted as a “supply shock.” The economic effect of disruptions to supply chains would be similar to that of the 1970s oil embargo. A sudden drop in productivity would reduce our economy’s output of goods.
It followed that the Federal Reserve would be nearly powerless to undo the damage. The Fed typically combats recessions by acting on the “demand” side of the economy. By reducing interest rates, it can, for example, lead more people to buy houses, and their increased willingness to spend money boosts levels of economic activity. But central banks can do nothing directly to increase productivity. The Fed cannot repair supply chains, or stop a virus from spreading.
There was another reason not to look to the Fed for help. Interest rates were already low, so the Fed had little room to reduce them further. The ubiquitous phrasing had it that the Fed was “out of ammunition,” or nearly so. Fed officials themselves said that Congress would have to do much of the work of softening the blow to the economy. Pessimistic though this view was about the Fed’s capacity to respond to this crisis, it had a positive implication: If the danger from the virus was brought under control, a recovery could occur quickly as supply chains were repaired.
But there are reasons to doubt this widespread view, and to believe that there is more the central bank can and should do for the economy. Let’s start with what ought to be a puzzle. If the economy were primarily beset by a supply shock, inflation ought to rise. Think of the oil embargo’s effect on prices. But just the opposite has been happening.
The difference in yield between bonds that are indexed for inflation and those that are not gives us a rough measure of market expectations of inflation. By that measure, expected inflation over the next five years began a vertiginous fall in mid February. So did expected inflation over the next ten years. The prices of key commodities told the same story.
At around the same time, expected federal-funds rates for the future fell. Futures markets revised the projected rate for January 2021 downward. And the projected rate for January 2022. And for as far out as January 2023.
Markets cannot see the future, but they are pretty good at processing current information that bears on it. Their implicit projections do not easily fit the hope that a short, sharp recession will be followed by an equally rapid “V-shaped” recovery. They suggest instead that we are at best in for a prolonged period of low growth after the contraction. They further suggest that this low growth will be associated less with continuous supply disruptions than with a persistently depressed willingness to consume and invest: with “demand,” in other words. (Hence the long-lasting decline in expected inflation.)
A reduced propensity to spend money on consumption and investment is equivalent to an increased demand for money balances. In a panic, we want to hold on to more of our money. Individual households and businesses can accomplish that goal by spending less. In the aggregate we can’t do it that way: If we all try to spend less we all have less coming in, too. We can, however, attain our goal through a falling price level (or a price level that rises less than it otherwise would); the real value of our money balances thereby increases. Or rather, we could attain it that way if prices were sufficiently flexible. But there are a number of rigidities that prevent this kind of smooth economic adjustment. Mortgage payments, for example, do not drop in response to reductions in spending and prices.
There is also abundant evidence that wages, especially in modern economies, are not flexible downward. Consider two scenarios. In one, the price of everything drops 2 percent and so do everyone’s wages. In the other, the price of everything rises 2 percent and so do wages. In theory, employers and employees ought to be indifferent between these situations: The real wage, the value of a paycheck after adjusting for the price level, stays flat either way. In practice, though, the first scenario of widespread pay cuts doesn’t happen. If the level of spending throughout the economy falls enough that payments to workers must drop too, a lot of those reductions in payments will come from layoffs. That’s what happened during the great recession: The average real wage actually rose.
The other, less painful way for money balances to rise is for monetary authorities to create more money: to increase supply to meet demand. Each unit of currency is then worth less than it would have been without that money creation, but households and businesses are able to keep a higher proportion of their income and assets in cash or near-equivalents without the need for a general reduction in prices and wages. Even better, the increased supply of money should reduce demand for it. There is less need to hold money if it does not appear to be growing scarcer and more valuable.
Markets appear to be anticipating an extended period of an elevated demand for money balances that is not met. That would explain why inflation expectations have fallen. It would explain low federal-funds rates in the future: If the expected future path of spending is pulled downward, so will be the interest rate the economy can sustain. Lower prospects for economic growth plus lower prospects for inflation (which add up, mathematically, to lower prospects for spending) means lower interest rates too. An unaccommodated rise in money demand also partly explains the recent strength of the dollar, and even part of the decline of stocks. Falling future spending means falling future income, which means falling asset values now.
There is recent precedent for such a series of events. Spending, which had been growing at roughly 5 percent a year for decades, fell during the Great Recession of 2008–09. Afterward it did not rise more quickly so as to return to its previous trendline. It instead settled in at a lower growth rate from a lower level. As a consequence, inflation also generally stayed below the Federal Reserve’s official target of 2 percent per year.
At the time, the Fed was commonly said to have done all it could, and various theories were advanced to explain why central banks no longer had the power to increase inflation. But the Fed hadn’t done all it could. It could have done more quantitative easing, or stopped paying banks interest on excess reserves, or said that it would tolerate inflation above 2 percent for a time to make up for being under it for so long. Or it could have committed to not raising interest rates until the 2 percent target had been hit. Instead it raised rates nine times from 2015 to 2018 while remaining below the target.
The Fed may have chosen the course it did, as opposed to a more expansionary one, because of an excessive fear of inflation. Or it may have had a faulty model of the economy, continually overestimating how high inflation was about to run. Or it may have balked at using more of the unconventional methods of loosening monetary policy that had already drawn it criticism. A lot of conservatives ten years ago were warning that quantitative easing and low interest rates threatened us with runaway inflation. Whatever the combination of reasons, markets may believe that such concerns will keep the Fed too tight in the aftermath of this crisis too.
It would be grossly unfair to accuse the Fed of inaction. It has cut interest rates to nearly zero, albeit a bit more tardily than President Trump wanted. (Trump has been more dovish than the Fed for most of his presidency, and his instincts on this question have generally been better than its.) It has resumed its quantitative easing and expanded the class of assets it is purchasing as part of it. It has created new lending facilities. Yet monetary conditions have tightened considerably anyway: Expected spending and inflation have fallen.
What the Fed has not done is suggest it has in any way altered how it thinks about its inflation target. If it said that its quantitative-easing and interest-rate policies were geared toward ensuring that the level of spending and prices in early 2022 would be the same as if this crisis had never happened — that it would do whatever it took to attain such results — it might powerfully reshape expectations for the better. It would be committing to offset any swings in money demand. To the extent that this commitment was credible, the Fed would be raising expected inflation, spending, and interest rates, which in turn ought to put a floor under asset values and spending now.
Economic activity, employment, and asset prices would still be negatively affected by the virus and the efforts made to lower its toll. And other parts of the government would still have important roles to play. The Fed can’t procure ventilators. Expanding unemployment insurance was, and continuing to monitor the need for changes to it is, a job for Congress and the president.
What the Fed can do is prevent the crisis from, as it were, infecting our monetary system. And what it can do, it should do.
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