Central Banks need a new pandora box for financial markets

The list of reasons that the US Federal Reserve shouldn’t have cut interest rates is long. Lower rates in our opinion will do nothing to address the root cause of potential economic distress, namely supply disruptions and halted economic activity because of the coronavirus. It comes as the Fed is already low on firepower to offset an economic slump, because of perpetually low interest rates.

And the evidence that the US overall economy is already suffering because of the virus is in our opinion thin to nonexistent. There hasn’t been so much as a single week of elevated claims for jobless benefits, for example, usually an early warning sign of economic trouble.

Oh, and the action for further rate cuts came after a week of plunging stock prices and public pressure for rate cuts from President Donald Trump. That means that by taking actions, the Federal Reserve chair, Jerome Powell, creates at least the appearance that he is reacting to the latest market sell-off or to presidential pressure.

But the thinking behind the decision by Powell and his colleagues to cut their target interest rate by 0.5% despite all of this is in our opinion not complicated. It was a judgement that just because you don’t have the right tools for a job doesn’t mean you shouldn’t use the tools that you do have.

When the Fed or any other central bank cuts interest rates, it tends to support financial markets and overall activity in the economy. The speed and magnitude of that effect are always subject to debate, as is how to trade off the desire for a hotter economy with other concerns like avoiding inflation or financial bubbles. Inflation concerns are most probably the biggest reason why European Central Bank president Ms. Lagarde has not cut interest rates further last month.

In the case of the US, bond market prices had moved in ways that suggested investors viewed additional interest rate cuts as a near certainty as US interest rates are still positive compared to the European Central with minus 0.5 or Switzerland with minus 0.75. The question in the US was in our opinion not so much whether to cut rates to stimulate the economy, but whether to resist the signal, holding interest rates steady and thus tightening the money supply. This is why Ms. Lagarde of the European Central Bank announced an additional 120 billion Euro stimulus bond package by the end of the year in addition to the existing 20 billion Euro monthly bond purchase.

When Fed officials looked around at the evidence that the economy was heading for a meaningful slowdown because of the speed of the virus, at a time when inflation in the US compared to Europe was not a worry, they reacted with the imperfect tool that they have.

Let us explain it in a different way:

Think of their role in this by imagining a town with a looming crisis: a major hurricane for example. Everybody in town would have a job to do. The most important of those jobs involves directly protecting the town from the storm. Civil engineers would want to check on and shore up sea walls. The local government would set to work putting sandbags in place. Then there is a second rung of those with less visible but equally urgent tasks. The local hardware store would stock up on emergency supplies. Community centers might prepare to shelter people who lose their homes. What role, in this scenario, would you expect the local bankers to play? Their job isn’t as important as that of the civil engineer or the people installing sandbags or the hardware store proprietor. But that doesn’t mean they can’t help things. They could make affordable loans available to anyone who needs extra cash to stormproof equipment, and promise to be patient with repayment terms for businesses that are affected by the storm. These aren’t the first, second or third most important things to happen to get ready for the storm, but they are constructive, responsible actions the bankers can take that reflect the depth of the looming crisis.

That is the central bank’s role in trying to contain the economic fallout of coronavirus. It can’t stop supply chains from being disrupted or the freeze-up of certain types of business activity, like travel and tourism.

What rate cuts from central banks like the Fed can do, however, is try to help prevent those disruptions from spiraling into an economy wide recession. The central bank will most likely take other actions, some of them beneath the radar, to try to encourage a steady flow of lending to businesses and consumers in the event of further coronavirus disruptions.

There has been a recurring idea ever since the financial crisis that the central banks are the only game in town in economic policy – that they have used their interest rate and quantitative easing policies to try to stabilize the economy because political authorities will most probably not. There are rumblings that the US and other world governments will consider further fiscal stimulus to pair with the easier monetary policy to try to keep major economies afloat by producing more and more debts now reaching worldwide 250 trillion US-Dollar. Of course, an effective response by public health authorities can do more than either fiscal or monetary policy alone.

Back to the analogy of the town facing a hurricane: we are in an unusual situation in which the local government doesn’t seem to be laying sandbags effectively. So people in this town might put more focus on the actions of the bankers than is warranted. That is exactly where the Federal reserve found itself – doing what central bankers do, and hoping that public health authorities and fiscal policymakers in Congress do their jobs as well including US President Donald Trump.