More and more publicity is being given to concerns about how policy makers might respond to the spread of the coronavirus.
The Federal Reserve has been near the top of this list. What can the Fed do? Is the Fed ready to act? And so on.
The More Dramatic Response
Kevin Warsh, former member of the Board of Governors of the Federal Reserve has written an opinion piece in the The Wall Street Journal titled, “The Fed Can’t Wait to Respond to the Coronavirus.”
Mr. Warsh writes,
In a coordinated move alongside the people’s Bank of China, the European Central Bank, and the Bank of England, the Bank of Japan and other so willing, the Fed should announce a 0.25-percentage-point interest-rate cut and make clear it’s open-minded about further action. …Global action would help make the most of scarce policy ammunition.
Mr. Warsh goes even further:
We simply don’t know what will happen. The Fed should be in the business of responding to ‘tail risks’—unlikely events that would have highly damaging effects on output and inflation—not fine-tuning around the base economic outlook.
The Fed Can’t Do Much to Stimulate the Supply Side
Justin Lahart, also writing in the The Wall Street Journal, contends that “The Fed Can’t Inoculate the Economy From Coronavirus.”
The problem that Mr. Lahart sees is that the major impacts of the coronavirus will be on the supply side of the economy and “lowering borrowing costs would do little to counteract the social-distancing efforts officials put in place and worried businesses and consumers adopt.”
He adds, “Fed easing wouldn’t make many people suddenly decide to go to the movies. Easing policy would still do some good. It could alleviate the financial burden on companies experiencing supply and sales disruptions.” And, after the trouble has passed, “easier monetary policy could help speed the economy toward recovery.”
The Fed Must Stand Ready
Federal Reserve Chair Jerome Powell has stated that the Federal Reserve is prepared and is watching the situation very closely. Over the two years that Mr. Powell has been Fed chair, he has been able to build up some confidence that the Fed, under his watch, will adequately respond to situations as they arise.
I believe that the strong US dollar is one piece of evidence that investors in global markets do have some faith in the Fed and its leadership.
The biggest issue right now is that there is so much uncertainty surrounding the spread of the coronavirus and about what exactly it will do to supply chains and markets and investor psychology.
Using terminology of former US Defense Secretary Donald Rumsfeld, the situation right now is one of unknown unknowns. This is why Mr. Warsh talks about being concerned with “tail risks.” We really don’t know what might happen.
And so the Federal Reserve and the business and investment community need to stand prepared.
Financial markets don’t like uncertainty. As a consequence, markets become more volatile when the fear of uncertainty grows. And that is exactly what we are seeing.
Mr. Lahart tells us that investors are expecting the Fed to calm any disturbances that might arise. He states, “Futures markets put about 90 percent odds on the central bank cutting rates at least two times before the year is out.” This is up from 25% in early January.
Trust in the Mr. Powell and the Federal Reserve is vital in these uncertain times.
The Federal Reserve Balance Sheet
Over the past week, the Federal Reserve did put reserves into the banking system and the “excess reserves” of the banks went up a little more that $21.0 billion.
The most interesting thing on the balance sheet was the continued reduction in the Fed’s use of repurchase agreements, which fell by $20.5 billion in the last banking week removing reserves from the banking system. This decline was offset by the Fed’s outright purchase so securities for its portfolio, a move that puts reserves into the banking system.
This is what the Fed has been doing since the banking week that ended Jan. 1, 2020. It appears that the “repo” crisis the Fed faced in the fall is over by now so the Fed could begin to reduce the use of repurchase agreements, which reached a peak on Jan. 1 of $255.6 billion.
Since Jan. 1, the repurchase agreements on the Fed’s balance sheet have dropped by $112.2 billion.
Note that the securities portfolio of the Fed rose by $103.3 billion over the same time period, suggesting that the Fed replaced almost all of the decline in repurchase agreements through outright purchase of securities, and more specifically, the outright purchase of US government issues.
During the past week the effective federal funds rate remained steady at 1.58%.
The future remains uncertain. As a consequence, financial markets will remain volatile.
However, I think Mr. Powell will move when need be and I believe that any move will be great enough to overcome the “tail risk” discussed above. I believe that Mr. Bernanke, when he was the Fed chair, showed that the Fed’s response needs to be sufficient to wipe out all concerns about the central bank’s participation in the rescue.
This lesson learned will be the foundation of the Fed’s response to the unfolding story.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.