Coronavirus: was the Fed cutting rates the right thing to do?
Coronavirus: was the Fed cutting rates the right thing to do?
Only with the right strategy can central banks avoid tipping the global economy into recession
The spread of the new coronavirus or COVID‐19 has wreaked havoc in financial markets and in economies across the world. In the past week equity markets have fallen very steeply, the US Treasury bond yield has fallen to an all‐time low of 0.7%, the Chinese economy virtually came to a standstill in February, and elsewhere tourist and business travel has collapsed, conferences across the world are being cancelled, and supply chains for the production of goods have been disrupted.
In my view these reactions are understandable only in the short term and in light of the fact that nobody can accurately forecast the course of this scourge. Markets hate uncertainty, and the unpredictability of the outcomes – severity, duration, country coverage etc – has made this outbreak of viral sickness all the more frightening to many people.
In the medium and long term the US economy is in very good shape and the business cycle expansion is set to continue. The reasons are first that balance sheets are sound (despite some misdirected criticism of non‐financial sector leverage) and second that there is ample monetary support for continued growth with low inflation. Broad money growth (aggregates such as M2, proxies for M3, and other measures including shadow banking) has remained buoyant since April/May 2019, rising – in the case of M2—from 4% to 8% and even higher growth rates for broader measures of money. There is therefore absolutely no question of a credit squeeze within the US economy.
The problem is mostly elsewhere and especially with supply chains in Asia. As Zoltan Pozsar of Credit Suisse has neatly summarised the problem, “Supply chains are payment chains in reverse.” This is probably where the stress will be felt.
Suppose a supply chain consists of four entities: (1) a supplier of raw materials, (2) a maker of basic industrial goods (steel, plastic, etc), (3) a manufacturer of semi‐finished or partly assembled items, and (4) the maker/distributor of the final product. At each stage there is a payment in the other direction: from the final maker (4) to the provider of semi‐finished parts (3), from this intermediate producer to the initial maker of basic industrial goods (2) and finally to the provider of the raw materials (1).
There are three key aspects of this “financial supply chain”. First, the goods may be high value‐added (electronics, robotics, car components, or fashion goods) or low value‐added (garments, shoes, cheap manufactured toys and household goods). Second, the supply chains mainly involve Asia – though of course there are some supply chains exclusively in America (Mexico, Canada and the US), or within Europe. Third, the trade finance that underpins this activity is mostly US dollar‐denominated and is supplied by banks in Japan, Korea, Taiwan, China and Hong Kong. Now while these banks are backed up in their local currency markets by the central banks of Japan, China, Korea Taiwan etc, their access to dollar funding is limited, notwithstanding the large foreign exchange reserves held by Asian central banks. If there are to be stresses, they will show up in these peripheral markets first and will then ricochet onwards to US banks (as suppliers of dollars) and ultimately to the Fed as the supplier of dollars or dealer of last resort.
These funding problems may already have started to show up in the US money markets. The term repo auction conducted by the New York Fed on Thursday was three times oversubscribed: bids were US$72.55 billion compared with $20 billion offered. In other words, dealers are concerned that over the next two weeks they may need cash to meet demand from their correspondent banks in Asia or to ensure they can bid in the up‐coming US Treasury auctions.
So how should the Fed respond? On Tuesday the FOMC decided to cut the range for the Fed funds rate by 50 basis points to 1.00‐1.25%. But was that the right thing to do?
In my view this is typical of a monetary policy that has become detached from the needs of markets and is too much driven by misleading theories about what interest rates can achieve. At the end of the day, monetary policy is not about interest rates; it is about providing the right amount of funding or the right quantity of money.
To see this, consider that over the past year money market funds have grown from $2.6 trillion to $3.3 trillion ($700 billion). One risk with the “interest rate only” response is that by steepening the yield curve the Fed simply entices these funds to move from the short‐term dollar funding markets ‐‐ where the funds will be needed over the next few weeks ‐‐ to the long‐term Treasury market. This would only exacerbate the funding stress.
The right response is to follow Walter Bagehot’s classic dictum: supply ample funds at a penalty rate against decent collateral. In other words, the Fed needs to supply liquidity to deal with the panic – whether by QE purchases of long bonds, or by T‐Bill purchases, or by repos, or ‐ best of all ‐ by increasing the amounts of US$ swaps available to the central banks of Japan, China, Korea, Taiwan and Hong Kong. (Another possible solution is that Asian central banks find a way to repo their US Treasuries in exchange for dollar cash, and then lend that cash – against collateral ‐‐ to local companies that need dollar funding.)
After the panic is over the liquidity can be withdrawn so that it does not leave an excess of funds in the market that might later generate inflation. The withdrawal of funds can easily be done after the current stresses have been overcome.
As far as the virus is concerned, my understanding is that viruses do not survive for more than a few hours in ultra‐violet light. This is why the common cold is a problem in the northern hemisphere’s winter when the amount of UV is very limited, and why there are currently only very few cases of Covid‐19 in the southern hemisphere. As a result, the phenomenon will disappear with the coming of spring and summer and greater amounts of UV‐light in those months.
To conclude, my view is that the coronavirus epidemic or pandemic is a short‐term problem which need not tip the global economy into a recession, but to prevent that from happening the correct strategy needs to be adopted. Currently, due to the acceleration of M2 money growth in the US between April and January (from 4% to 8% p.a.) there is ample money in the economy. However, the stresses of this temporary, but sharp and significant setback urgently need to be addressed in the way that central banks have historically dealt with such panics in the past.
If this is done, the bounce‐back during the summer months will be strong and sustained.
John Greenwood is Chief Economist of Invesco.
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