Monetary policy cannot solve the coronavirus crisis — but it can prevent secondary effects

At first glance, the coronavirus crisis might seem to have little or nothing to do with monetary policy. Former Treasury Secretary Larry Summers opposed the recent cut in interest rates, telling Bloomberg TV that lower rates cannot mend supply chains or stop the spread of the virus. That view seems uncontroversial — indeed quite sensible. And yet the epidemic does have important implications for monetary policy. 

Let’s start with the fact that the financial markets don’t seem to agree with Summers. Interest rates have fallen sharply at almost all maturities, from 3-month Treasury bills to 30-year Treasury bonds. The sharp decline in interest rate futures is a direct prediction by investors that the Fed will continue cutting rates sharply.

Of course, the mere fact that markets expect a rate cut doesn’t by itself mean the cut would have any impact on the economy. However, equity markets have recently been especially sensitive to statements made by Fed officials, an indication that monetary stimulus would have a significant effect. Stock prices recently soared on expectations of monetary stimulus. Why might that be, given that the Fed cannot stop a virus, fix Chinese supply chains or push people onto cruise ships? 

Some pundits have assumed that the coronavirus is primarily a supply shock, whereas monetary policy affects aggregate demand, or total spending in the economy. According to this view, there’s relatively little that monetary policy can do to remedy the situation.

In fact, the Chinese production that Americans rely on is already coming back on stream, and the actual problem has rapidly shifted from supply to demand. There are all sorts of indicators of a sharp drop in aggregate demand, from plunging interest rates to collapsing oil prices to lower inflation expectations in the bond market. Any single indicator may be faulty, but it is difficult to ignore the wide range of signs now suggesting weak demand ahead.

Monetary policy is expressly designed to address these types of aggregate demand shortfalls, and indeed there’s a sense that the Fed’s primary duty is to create a stable growth path for demand in order to stabilize inflation and employment. If demand is likely to fall sharply in the near future, then a more expansionary monetary policy can help ensure that the Fed hits its 2 percent inflation target. Right now, it looks like inflation will fall well short.

To be sure, the Fed cannot work miracles. It may be impossible to achieve its targets over the next few months, especially if a significant part of the economy shuts down due to coronavirus fears. What the Fed can do is ensure that expectations for next year’s economy remain on track.

To this end, the Fed should do enough monetary stimulus so that market forecasts predict roughly on-target growth and inflation in 2021. Bullish expectations for next year – hope on the horizon – can reduce the severity of any near-term decline in output that might occur due to a fall in spending.

Unfortunately, right now it looks like the markets are not just expecting a weak 2020, but also a weak 2021 and 2022. If the economy were expected to bounce back in six months or a year, the yield on 10-year bonds would not have fallen to 0.5 percent and the yield on 30-year bonds would not have fallen to 1 percent. These unusually low yields, as well as plunging stock prices, reflect market expectations of weak spending for years to come. If the market is correct, then there is a risk of much-higher unemployment, just as bearish market forecasts in late 2008 ultimately were borne out by much-higher unemployment over the next few years.

Here’s the thing to remember: Monetary policy cannot solve the direct problems resulting from the coronavirus, but it can prevent them from spilling over into the broader economy, resulting in higher unemployment. To use a viral analogy, the Fed cannot cure a common cold, but it may be able to prevent the cold from developing into bronchitis or pneumonia. Think of monetary stimulus as a sort of antibiotic for the economy.

Therefore, the Fed should also immediately end its policy of paying interest on bank reserves, which encourages banks to sit on funds rather than loan them out. Then it should ask Congress for permission to buy a much-wider range of assets during an emergency. (Congress should do this anyway, but is unlikely to do so without the Fed’s prompting.)

Finally, the Fed should buy as many assets as necessary to boost expectations for growth and inflation during 2021 and 2022. A determined central bank can create almost unlimited spending, and indeed in normal times there’s a risk of excess inflation. But these are not normal times, and the actual risk today is too little spending and too little inflation.

Scott Sumner is an emeritus professor of economics at Bentley University and director of the Program on Monetary Policy at the Mercatus Center at George Mason University.