The Fed Will Need Help Battling Coronavirus

(Bloomberg Opinion) -- The coronavirus threatens to have wrenching effects on the U.S. economy. Growth will be hurt by supply disruptions that depress production and by falling consumer demand as discretionary activities are constrained to slow the spread of the virus.

So how will the Federal Reserve respond? 

At this point, more short-term rate cuts seem certain. After all, the outlook has deteriorated since the Fed’s 50 basis point cut on March 3. Moreover, historical experience indicates that rate cuts between Federal Open Market Committee meetings have typically been followed by rate cuts at the subsequent FOMC meeting. Finally, the language accompanying the last rate cut -- that the FOMC would "act as appropriate" -- also has been a reliable predictor of future rate adjustments. Thus, it would be very surprising if the FOMC didn't cut its federal funds rate target by 50 basis points, or possibly more, at next week’s meeting.

Less certain is whether the FOMC will find it necessary to bring back the types of tools used in the financial crisis. Those fall into two camps: to make monetary policy more stimulative when short-term rates are near zero and to supply liquidity to financial markets and to banks and other financial-market participants.

The first group of tools includes forward guidance on the future path of short-term interest rates and quantitative easing -- that is the central bank’s purchases of long-dated fixed-income assets. The second group includes discount window facilities and other special tools to boost liquidity in credit markets. 

The decision to use the monetary policy tools such as forward guidance and quantitative easing will be straightforward. If the Fed has pushed short-term rates to zero and the economic outlook suggests the need for greater monetary stimulus, these tools will be used. They are now part of the Fed’s standard tool kit.

In contrast, establishing special liquidity facilities is a much bigger stretch for the Fed for several reasons. First, it is unclear whether significant liquidity problems will arise. Even though market declines have been substantial and the economic outlook has darkened, markets are functioning relatively well. Furthermore, key indicators of financial-system stress are well below the levels seen during the financial crisis. 

Perhaps, the Fed will restart the term auction facility, which was put in place during the financial crisis to reduce the stigma for banks that borrow from the Fed’s discount window. But whether this is necessary or would even been used if implemented is uncertain at this point. In a similar vein, dollar liquidity will undoubtedly be made available. The foreign-exchange swap network is still in place.  But stress levels will have to climb a good deal more before it's used in any significant way. 

With respect to the Fed’s emergency-lending programs that were used during the financial crisis, this seems unlikely at this point for several reasons. First, the current situation isn't about financial-market dysfunction and the loss of trust among financial counterparties. Primary dealers can still obtain funding, commercial paper issuers retain access to the market and asset-backed securitization markets are still working. The current turmoil will have to take a sharp turn toward market dysfunction to put emergency-lending authority on the table. The lending facilities that the Fed implemented during the financial crisis came only after a freeze-up in markets, a sharp rise in funding costs and a deterioration in market access even for highly rated borrowers.   

Second, the bar to resorting to emergency lending was raised by the Dodd-Frank Act. Not only do such facilities now have to be broad-based, but they also require the approval of the secretary of the Treasury. Moreover, the Fed needs to ensure that it won't lose money when it extends credit. In the case of the commercial-paper market and the asset-backed securitization markets, this might be difficult to achieve without broad enrollment and significant registration fees or explicit government support.  Recall that some of the emergency facilities put in place during the financial crisis were backstopped by support from the U.S. Treasury.    

The stresses that emerge as a result of the coronavirus are likely to be very different from those that occurred during the financial crisis. This time we are likely to see considerable stress on small businesses that encounter cash-flow problems and on households, especially if unemployment spikes. 

These types of problems probably are better addressed through fiscal policy than monetary policy. Payroll tax cuts, sick-leave pay, extended unemployment benefits, and block grants to state and local governments to forestall layoffs should all be considered. 

The Fed has a few good hammers, but not every problem is a nail. The coronavirus is likely to lead to a host of challenges to which monetary policy is not well-suited. The sooner this is widely recognized, the faster more appropriate measures can be implemented by the administration and Congress.  

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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