The Fed Has Plenty of Ammunition Left for Coronavirus

(Bloomberg Opinion) -- Federal Reserve chairman Jay Powell and his colleagues made the right call in cutting the federal funds rate by 50 basis points. They knew full well what the naysayers would claim: A rate cut is an overreaction; it can't conjure a coronavirus vaccine into being; the central bank will have little ammunition left when it really needs some. It's a good thing they ignored all of that.

It's true that the Fed cannot stop the coronavirus from harming the supply side of the economy. It can't rescue the travel industry or make up for lost work days. What it can do is prevent a supply-side hit from generating an additional demand-side one.

That could happen in two ways. First: When growth prospects fall, as both common sense and economic forecasters say they have been doing, the neutral interest rate — the rate that neither contracts nor stimulates the economy — falls too. If the federal funds rate was already at the neutral rate, then leaving it in place as the neutral rate falls means adopting a contractionary policy. (If the fed funds rate was above the neutral rate to start, then leaving it in place means adopting a more contractionary policy.) So a cut was warranted just to reflect the new reality.

Second: The coronavirus and the attendant public alarm could lead to an increased demand for money balances — or, to put it another way, a reduction in the velocity with which money changes hands, as consumers and investors grow more skittish. A loosening of monetary conditions is needed to accommodate that shift in preferences, too.

If these dangers were materializing, we would anticipate falling inflation expectations and an inverted yield curve. That's exactly what we have been seeing.

The concern about ammunition, although it has been a recurring one for the Fed over the last 10 years, has always been misguided. For one thing, even at low interest rates the Fed has other forms of ammunition. It can, for example, engage in quantitative easing. The chief obstacles to such a course are political, not economic.

More important, the ammunition metaphor is misleading. In recent weeks, as monetary conditions have been tightening, expectations for future federal funds rates have been falling. The futures market's reaction to the Federal Reserve's rate cuts, on the other hand, has been higher expected future rates.

A tightening of money, including a passive tightening that occurs because of Fed inaction as economic conditions deteriorate, reduces future interest rates. By cutting rates now, the Fed has actually stockpiled its ammunition. Let's hope it has given itself enough.

To contact the editor responsible for this story: Tobin Harshaw at tharshaw@bloomberg.net

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

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

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