Tags: fed | credibility | virus | central bank | act

Fed Is Losing Its Credibility to Coronavirus

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(Matthew Veldhuis/Dreamstime)

By    |   Thursday, 27 February 2020 01:58 PM EST

Richard Clarida, the vice chair of the Federal Reserve, made a series of perplexing statements on Tuesday. First, he said that “the economic disruptions from China could spill over to the rest of the global economy.” Nonetheless, he then made clear that despite the rising threat the coronavirus poses to world growth, the Fed isn't planning to cut interest rates anytime soon. This raises the question of what the Fed perceives to be the costs of cutting interest rates. There are three possible arguments.  

First, the Fed might believe that the U.S. has safely contained the coronavirus, an argument made Tuesday by Larry Kudlow, director of the National Economic Council.   

Second, the Fed might think that the coronavirus is primarily a temporary supply shock, comparable to that of a brief run-up in oil prices caused by Middle East turmoil. Such a shock would lead to an unwelcome, if temporary, rise in inflation. Easing interest rates would only add to those inflationary pressures.

In my view, both of these arguments represent a misunderstanding of the nature of the largest economic threat from the virus. The outbreak has triggered a huge burst of risk aversion in financial markets. We should expect that risk aversion to manifest itself as a drag on household and business spending on travel and many other services. There is, of course, the possibility that this risk aversion continues to grow, creating its own negative dynamic: As consumers and businesses respond to alarming events, they pull back, causing growth to slow still more.

This cycle is why the economic threat from the virus is so unnerving. If the cycle develops, it would represent an adverse demand shock that will weigh on businesses’ willingness to hire and raise prices. The appropriate monetary policy response, of course, is to ease interest rates.

The third and biggest factor behind the Fed’s unwillingness to cut is the most troubling -- the Fed simply doesn’t like low interest rates. This antipathy to low rates was a key factor in its premature decision in late 2015 to start raising from the ultra-low rates that had prevailed since the financial crisis. And that same aversion to easy money has led the Fed to undershoot its inflation target for most of the past decade. 

The irony is that the Fed’s dislike of low short-term interest rates has created the lowest long-term interest-rate environment in modern U.S. history. Investors no longer are certain that the Fed is willing to follow policies that will protect growth from downside risks. This loss of institutional credibility has pushed up the demand for long-term bonds and pushed down long-term yields to record or near-record lows. 

The Fed is facing the growing threat of a significant fall in aggregate demand. It needs to cut rates now in response to this risk. Failing to do so will only accelerate the ongoing collapse of its institutional credibility.

Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

© Copyright 2025 Bloomberg L.P. All Rights Reserved.


NarayanaKocherlakota
The central bank is failing to act in the face of a threat to world growth, and for no good reason.
fed, credibility, virus, central bank, act
514
2020-58-27
Thursday, 27 February 2020 01:58 PM
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