By Vicki Schmelzer
NEW YORK (MaceNews) – The spread of COVID-19 globally is likely to create both demand and supply shocks, said Federal Reserve speakers Friday.
“Supply shocks cause demand responses, cause effects in the banking system that are spillovers,“ said New York Fed President John Williams in Q&A following remarks to the Shadow Open Market Committee meeting.
“The judgement we have to come to as policy-makers, especially in this kind of situation where we don’t have the data flow and all the analysis. — we’re basing this on looking at projections of developments in terms of the coronavirus, in terms of what we are seeing around the globe, “ he said.
Initial analysis points to a “supply shock aspect,” he said.
But also “clearly there is an effect on the financial markets – clearly there is effect on confidence and it’s got a major uncertainty aspect,” he said. Research shows that “heightened uncertainty tends to cause people to pull back from investments, whether businesses or households.”
He stressed that while central banks and monetary policy are secondary when dealing with the outbreak, which is “foremost a health issue,” central banks and governments have key roles too.
“I think governments do have an important role to play as well in supporting financially and through other policies and health care response across the globe, and if needed, providing fiscal stimulus to the economy,” Williams said.
With the coronavirus spreading, there is “already evidence” of both a demand and supply shock, echoed Boston Fed President Eric Rosengren.
“If it’s only a supply shock, then lowering interest rates doesn’t do much good,” he said.
But if businesses start cutting back on investment, and employment falls, and the Fed finds it is below its inflation target and the U.S. is not at full employment, then “we would want to use monetary policy to try to reach the dual mandate that we have,” he said.
In Rosengren’s prepared remarks, he noted that “as investors are more aware of the likelihood of short-term rates hitting the zero lower bound, they have been more willing to use U.S. Treasury bonds as hedges against recession risk.” This awareness has resulted in a sharp drop in 10-year U.S. Treasury yields, which have fallen from around 1.80%, on January 21 as the first cases of corona virus appeared in the U.S., to sub-1.0% levels.
“If the economic reaction to the coronavirus does result in the funds rate falling to its effective lower bound, this heightened sensitivity of the 10-year U.S. Treasury rate to adverse news raises the possibility that the 10-year U.S. Treasury rate could follow close behind,” Rosengren said.
In this case, the Fed would have “little room” to lower interest rates via the purchases of long-term Treasury securities as it did in response to the U.S. financial crisis.
“Such a situation would raise challenges policymakers did not face even during the Great Recession,” Rosengren said.
Kansas City Fed President Esther George, taking part in an afternoon panel discussion on “The Fed’s Balance Sheet and Credit Policy,” observed that “to the extent that large-scale asset purchases succeeded in their aim of creating a wealth effect, they also played some role in contributing to elevated asset valuations.”
“These effects, together with the perception that interest rates will remain at historically low levels for a prolonged period, can lead to a buildup of financial imbalances that ultimately pose risks to the real economy,” she said, adding that “Experience has shown that these imbalances can develop in sectors outside the lens of regulators and, as we witnessed a decade ago, can unwind with little warning.”