Central banks throughout the world are charged not only with price stability, but also with maintaining financial stability. For example, the Federal Reserve is charged with maintaining maximum employment and stable prices and the Bank of England now has an entire new building packed with financial regulators.
Historically, the Fed has achieved its employment mandate by raising the interest rate when output is growing at what the Fed deems to be an unsustainable rate and lowering the interest rate when the economy is, in the judgement of Fed policy makers, about to enter a recession. In recent years, a chorus of economists has fretted that the Fed Funds rate, currently at 1.58%, is too low for a cut to have a substantial impact if the economy were to head into a major recession. Those fears are now being realized in a major way.
The current expansion that began in June of 2009 is the longest in post-war US history. The effect of Coronavirus on economic activity will mark the end of that expansion and we are now seeing the fears of market participants reflected in a stock-market crash with major market indices that dropped by more than 10% last week, wiping out all of the gains from the previous year. The Fed response of a fifty-basis point cut has not calmed fears. To the extent that the market reflects fundamentals, a fall in values caused by expected future supply disruptions is to be expected and is not necessarily a bad thing. But there is a real danger that Coronavirus will spread not only though biological contagion, but through financial contagion.
The supply chain disruptions emanating from China will mean that there are fewer goods available for consumption in the US and Europe. A market response to that disruption should result in a temporary increase in prices as markets allocate a reduced physical supply to a constant nominal demand. But movements in the five-year forward inflation expectation rate suggest that market participants expect the opposite. Inflation expectations by this measure have fallen by a half a percentage point in five days and they are currently in free fall. Markets are concerned that the supply disruption will trigger further demand cuts that lead to a doom loop of self-fulling expectations.
The stock market is driven not just by fundamentals. It is driven by fear. Market values are, to paraphrase Keynes, like a beauty contest in which the judges are not evaluating the natural beauty of the contestants, they are evaluating the opinions of the other judges of the competition. For every Warren Buffet, investing for the long run, there are ninety-nine investors looking to make a quick profit.
Day to day market fluctuations do not show up in the employment statistics. Persistent market fluctuations do. My published research documents that a 30% persistent drop in the stock market, if not contained, will lead to a 13.5% increase in the unemployment rate. Stock market crashes do not just reflect fundamentals arising from supply side shocks. They amplify those effects and can, sometimes, be independent causal factors that create recessions or deepen recessions arising from what would otherwise be relatively minor supply disruptions.
There are two ways in which stock-price movements feed back to the real economy. The first is through wealth effects on aggregate demand. When 401k stock portfolios fall by 30% and remain down for three months, households respond by cutting back on spending. The second is through wealth effects on aggregate supply. Many small and medium size businesses rely on the net wealth of their owners to guarantee business loans. When the asset positions of entrepreneurs fall substantially there is a chain reaction through networks of overlapping contracts that generates waves of bankruptcies and layoffs of workers.
For some time, the Fed has aimed to hit an inflation target of 2%. To achieve that target they lower the interest rate when inflation falls and raise it when inflation increases. There has been a chorus of views, to which I subscribe, urging the members of the Federal Open Market Committee to aim not for an inflation target, but for a nominal GDP target. The Fed should act, not to keep inflation at 2%, but to keep nominal GDP growing at a steady rate.
If central banks do not act in a more decisive manner soon, the supply disruption from Coronavirus will lead to a precipitous fall not just in employment and real GDP, but in nominal GDP. The supply side disruption shouldlead to a fall in real GDP. It should not be permitted to lead to a fall in nominal GDP. When short-term interest rates are at or close to zero, as they are now, cutting the interest rate is not sufficient to prevent financial collapse. As I have argued for more than a decade central banks and national treasuries should intervene directly by buying stocks.
Direct market intervention of a central bank is not unprecedented. During the Asian Financial Crisis the Hong Kong Monetary Authority invested in the stock market and their intervention is widely credited with preventing Hong Kong from experiencing the worst effects of the contagion that affected other countries in the region. The Federal Reserve is currently constrained by the Federal Reserve Act from directly purchasing stocks. The US Treasury is not and an emergency intervention to create a US wealth fund, backed by Treasury Debt that was subsequently purchased by the Federal Reserve Open Market Committee is one possible way that a policy of this kind could be quickly enacted.
Whatever happens in the next two months, the longest post-war expansion is about to come to an end. The depth of the ensuing recession will depend in no small part on the speed and effectiveness of the policy response.