No, but monetary policy can greatly magnify the damage from an epidemic.
Suppose an epidemic disrupts manufacturing supply chains. This is an adverse supply shock, which shifts the aggregate supply curve to the left. However, it does not directly cause a decrease in aggregate demand, or a decrease in nominal GDP. Instead, prices will rise and real GDP will fall. Monetary policy cannot fix that problem. But it can make the problem much worse.
If an epidemic disrupted manufacturing supply chains, then it would likely also reduce business investment, depressing the equilibrium (or natural) interest rate.
Now here’s where things get interesting. If the Fed did not cut its target interest rate in response to a fall in the equilibrium interest rate, then monetary policy would get tighter and NGDP would fall. Many workers would lose jobs in areas totally unaffected by the epidemic. Their loss of jobs would not be caused by the epidemic; it would be caused by a tightening of monetary policy. That would be very unfortunate. So while monetary policy cannot prevent an epidemic from hurting the economy, it can greatly amplify the damage, perhaps 10-fold.
How would we know if monetary policy is amplifying the damage from an epidemic? Observe the NGDP growth rate. If it slowed sharply from the recent 4% pace, then the damage to the economy would be primarily the fault of monetary policy, not the epidemic. If it continued at roughly 4%, and inflation picked up while RGDP growth fell, then monetary policy would have been appropriate. It would have refrained from adding insult to injury.
I don’t know if the Covid-19 (coronavirus) epidemic will get much worse and damage the US economy. But if it does, I do not expect Fed policy to be entirely appropriate. They would certain take steps to address the issue, but I think it quite likely that they would accidentally let NGDP growth slow sharply. I base this judgment on the fact that the Fed is already behind the curve, has already failed to react appropriately to the initial stages of the epidemic. The Fed’s target interest rate is already above the economy’s equilibrium rate, which has recently declined. They should have had a precautionary rate cut at the last meeting, especially given that policy is already too tight to hit their 2% PCE inflation target. It would have been “low cost insurance”.
PS. I have no proof for the following, but I suspect that the Fed did not refrain from a rate cut because they thought a rate cut would move them further away from their policy goal (2% PCE inflation), rather I believe they refrained from the rate cut because they’d prefer not to cut rates right now, for hard to describe reasons that have nothing to do with the likelihood of hitting their target.
I hope this doesn’t sound too critical, as I believe the Fed has done a very good job in recent years. But there’s always room for improvement. If (God forbid) the epidemic gets much worse over the next couple of weeks then a rate cut in March would be essential.
READER COMMENTS
Thaomas
Feb 24 2020 at 7:05am
I do wish the Fed had signaled that it really has a symmetric inflation rate policy and in a severe outbreak will allow inflation to rise above 2%. The failure to keep inflation averaging around 2% since 2008 is not a good sign.
marcus nunes
Feb 24 2020 at 7:38am
One problem is that the misguided Fed is afraid of “lacking firepower” (i.e. having at least 500 bp of interest to cut) to address the next downturn, instead of being concerned with how to avoid it!
Thaomas
Feb 24 2020 at 8:15am
As long as there are people willing to exchange other financial assets for credits to their accounts at the Fed, they will not lack “firepower.” It was not lack of “firepower” that caused them to stop QE.
Brian Donohue
Feb 24 2020 at 7:47am
“I believe they refrained from the rate cut because they’d prefer not to cut rates right now, for hard to describe reasons that have nothing to do with the likelihood of hitting their target.”
Holy non-explanation Batman.
P Burgos
Feb 24 2020 at 9:03am
I think that is the polite way of saying they have their heads firmly ensconced in their posteriors.
Warren Platts
Feb 24 2020 at 3:08pm
I am sure the Fed would never attempt to influence a presidential election!
Brian Donohue
Feb 24 2020 at 9:41am
Markets move quick and Powell has already earned a reputation as a guy behind the curve. 10-year Treasury at 1.375% right now. Pretty cool that the Fed increased IOER in January to 1.60% for some hard to describe reason diametrically opposed to their mandate.
Mike Sandifer
Feb 24 2020 at 11:07am
Even if the Fed weren’t behind the curve(yield curve. Thank you! I’m here all night.), the inflation targeting regime adds a nominal problem to the real problem. This would be a good time to begin a new average inflation rate targeting regime, which should represent a modest improvement.
I would add that not only will delaying easing make the easing less effective, but it will also mean we’re closer to the ZLB, which will further undermine monetary policy effectiveness under the current IT regime.
Indeed, I still think that is a problem, the risk of which was still sapping demand from the economy even apart from these latest real shocks.
Warren Platts
Feb 24 2020 at 3:36pm
If an epidemic disrupted manufacturing supply chains, then it would likely also reduce business investment, depressing the equilibrium (or natural) interest rate.
This seems counter-intuitive to me. If an epidemic disrupted supply chains, that should lead to thinking that putting all your manufacturing eggs in a single basket is maybe not the best idea ever. That in turn would lead to decisions to build new factories in unaffected regions, thus increasing business investment.
But I guess if interest rates are going down, that apparently is not happening.
Mark
Feb 24 2020 at 10:01pm
China accounts for something like 15% of global manufacturing exports, less than its share of global population. Thus, most companies are not putting all their eggs in the China basket; instead, Chinese capacity adds diversification.
Also, if the expected profits of building new factories in unaffected regions were greater than zero, companies would be doing so already regardless of the virus. The only clear way a virus in China could make it profitable to build new factories in other regions is by decreasing supply and increasing the price of the goods produced, thus making production more profitable, but we’re not really seeing prices go up (if anything, prices of many commodities at least are going down, showing that China is a major contributor to global demand as well as supply). Meanwhile, there are many ways in which a virus in China could decrease the profitability of building in other regions—the spread of the virus itself, decreased demand not only from China but also from overly worried people the world over, and the decreased availability of intermediate goods.
Thaomas
Feb 25 2020 at 10:43am
Scott has long maintained that NGDP targeting is better than dual mandate even with the prices side understood as a PL target as better dealing with both supply shocks and demand shocks. This is a good example of how to tell ex post if the Fed is targeting NGDP (with a supply shock, “full” employment may fall temporarily by and amount that is difficult to predict).
It would be helpful to know how he would operationalize this in real time. If the Fed expects a supply constraint from measures taken to slow down the spread of Covid-19 (especially if they will impose greater costs than necessary), what should the Fed do in the next meeting of the OMC? I suppose they will also need to take account of whether they think that in addition to the supply shock, consumers and investors will try to consume and invest less, meaning that there will be a demand shock coming on top of the supply shock.
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