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On March 3, the Federal Reserve unexpectedly cut its interest rate target by half a percentage point in a preemptive move to combat the economic risks caused by the coronavirus.
This was the first emergency rate cut since the financial crisis in 2008. Nevertheless, on March 9, the S&P 500 fell a stunning 7.6%. Given the Fed’s easing, and the subsequent stock market crash, the question naturally arises: Can monetary policy help avert an economic crisis?
Many commentators make it sound as if monetary policy has an almost godlike ability to boost the economy. President Trump, for instance, has long been jawboning the Fed to cut interest rates, as if that’s all that’s holding the economy back. When informed of the Federal Reserve’s rate cut, he stated: “Finally. Do it more. Do it a little bit more.”
But monetary policy is not omnipotent and cannot endlessly push the economy’s output above its potential. Right now, the growth of our economy’s potential is slowing.
The coronavirus is causing a negative supply shock, meaning goods are not being brought to market because global supply chains are disrupted. The Federal Reserve can’t cure the coronavirus with cheap money. Lower interest rates merely increase the demand for goods by encouraging households and businesses to borrow and spend.
But the fundamental problem caused by the coronavirus isn’t a lack of demand for goods, as was the case in 2008, but that there is not enough supply to meet demand. Some slowdown in economic growth is inevitable over the next few months, and monetary policy cannot prevent it.
However, what monetary policy can do is prevent this slowdown from needlessly triggering a financial crisis. Currently, there is a great deal of uncertainty about the medical and economic fallout of the virus. We aren’t sure how contagious and severe it is, or how the various countries affected will respond to its spread. Consequently, equity markets are in panic as investors seek safe havens and liquid assets—which causes the demand for money to spike.
In times of crisis, it’s the Fed’s job to forestall financial panic by providing the banking system with a super-abundance of cash to meet the larger demand. Failure to do so can lead to a recession.
How the Federal Reserve handles this fundamental job of central banking might very well determine whether there is a brief slowdown or the next recession.•
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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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