Can monetary policy prevent an epidemic from hurting the economy?
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.