Markets have been in turmoil as the U.S. reacts to increasing numbers of deaths due to and diagnoses of COVID-19 in its borders. On Sunday, March 15, the Federal Reserve cut its benchmark interest rate to almost zero and launched a $700 billion quantitative easing program. To get an idea of how the Federal Reserve may act in the coming weeks, Nash Wedderburn of GLG’s Financial Analysis team spoke with Dr. James Kahn, former Vice President of the Federal Reserve Bank of New York, on March 11. In the below Q&A, which has been edited for length and clarity, Dr. Kahn discusses possible rate cuts as well as whether fiscal policy can help in a situation such as the one created by the global pandemic.

What are we currently witnessing across the overall markets through the lens of the Federal Reserve? How does the Fed look to handle the current market tribulations?

The markets have been tremendously volatile, and that reflects the magnitude of uncertainty. But the Fed’s view is that not all problems can be handled by monetary policy. This is certainly a situation where the Fed sees itself as having a relatively limited role. That’s why it has been somewhat more reactive than active. For one thing, many of the economic impacts are heavily uneven across the economy. Specific sectors, such as transportation and entertainment, have been very negatively affected. Monetary policy is a blunt instrument for that kind of impact.

Even prior to this, when the coronavirus issue started, the Fed had cut rates. The Fed has always been concerned about the generally low-interest environment we face, and it’s why the Fed has kept rates a little higher than in Europe as well as the fact that the economic conditions here were stronger. But given where things are now, the Fed has cut between meetings, which is unusual in and of itself. The other intervention of the Fed is in supplying the repo markets with liquidity. It’s ramped that up considerably because of these developments, more than it had planned to. That will continue.

How will the central bank manage policy for a potential worsening COVID-19 scenario, given what we’re seeing right now?

There’s not much more it can do. It could conceivably cut rates down to zero. They will be reluctant to do that. I don’t see them going into negative interest rate territory, as has happened in Europe and Japan. I’m sure that Chairman Jerome Powell will be asked about that. I suspect he will demur from getting too specific but won’t provide a lot of encouragement that’s going to happen. The economy was very strong in February, as job numbers and other indicators had shown. We’re certainly not in a cyclical downturn. This has more the feel of a temporary event that could reverse itself relatively easily. It could obviously be a trigger for downturn, but the Fed wants to give itself some operating room should the economy worsen. If the rate is already at zero, that’s going to be a problem from their point of view.

It’s almost certain they’re going to cut at the next meeting, if not sooner. The total cut will probably be another 50 basis points ( editor’s note: the Fed cut it by 50 basis points on March 3), given where other similar market conditions are now. They want to make sure that repo markets and potentially other markets are not drying up in terms of liquidity and don’t seize up the way they did in 2008. They will be keeping an eye on markets where they can intervene. I would not expect them to do anything more than they’ve ever done in the past, using 2008 as a precedent. Not that this is as serious as 2008 by any stretch.

What are you looking to hear from Powell that will indicate something might be a little different, and what indicators may lead you to believe there may be more intervention?

It’s not out of the question, if markets continue to crash, that they could cut sooner, even though the next meeting is only a week away. But my best guess is they will cut 50 basis points. The subsequent meeting is another eight weeks or so after that. They could certainly cut an additional 25. They’re going to just be following the markets rather than actively trying to influence them. As they lower rates, they’ll be lowering, in parallel, the other rates they control, including their repo rate for their interventions, which is at 1%, whereas short-term treasuries are less than 50 basis points now. There’s some misalignment there. They will address that next week, and they’ll continue to keep rates in line with the market.

There’s a significant likelihood that this whole situation will stabilize between the next two meetings. Then you might see rates coming back up again. What the market has been responding to, in my view, is a small probability of a bad outcome. It’s likely not going to be that bad. If that becomes clear, in the next few weeks we’ll see a big recovery and a reversal of the Fed’s recent policies. But this is all in the realm of speculation.

On March 9, we saw that the Federal Reserve Bank of New York announced it was increasing short-term loans offered to banks as an attempt to keep cash flow running smoothly. Do you think that’ll continue to happen?

Not beyond what had already been planned. The main thing is the magnitude of uncertainty and however that resolves the degree of uncertainty. I’m not a virologist, but from everything I’ve read, warm weather seems to help, and all the measures that have been taken, whether they’re an overreaction or a sensible reaction, will help. Looking at the progression of H1N1 back in 2009-10, there was almost no response in terms of isolation. That ended up spreading to something like 50 million people and there were 11,000 deaths. As a rate, that’s very low. In the United States now, there are about 1,000 COVID-19 cases and a few dozen deaths. Not to make light of that in any way, but we’re so far away from anything on the magnitude of H1N1, and there were no measures back then to stave it off. But the Fed will continue to intervene, if needed. The loans you mentioned are basically repo market interventions, short-term loans to banks, and the Fed’s basically trying to keep that market from seizing up the way it did last September.

The Bank of England recently announced it will cut rates as well. Can you walk us through how entities, especially the European Central Bank (ECB), are handling the current climate and what you see coming in the next months as we start to unravel what’s going on with COVID-19?

The situation in Europe and including the UK is somewhat similar to here, although Italy has been much more adversely affected. The difference is they had been in a somewhat lower-growth, less strong economic environment to begin with, and rates have been lower. The Bank of England cut its rate to 50 basis points. I don’t believe they ever went negative. The ECB has already been at zero or negative. They’re basically charging banks for reserves in the hope that banks choose to lend out money rather than hold them as reserves. They’re talking about maybe even nudging that a little bit lower to minus 60 basis points. The Bank of England also has a little bit less scope. From what I understand, the ECB is even considering buying corporate bonds to support those markets. They have some latitude in the kinds of assets they can buy. Because they’re so close to the edge to begin with in many of their policies, there’s not a lot that they can do. Some of it seems symbolic; in other words, they want to act, but the potency and scope of what they can do is constrained.

What role will fiscal policy play in this situation?

The Trump administration apparently is advocating for a substantial payroll tax cut; Democrats in Congress are looking more toward more specific relief, like paid leave and things like that. I hate to be the voice of pessimism in terms of the efficacy of these policies, but given the nature of the drop in spending, I don’t see these kinds of fiscal stimuli helping that much. If people want to stay home and not spend, even if their paycheck is a little higher because of a temporary tax cut, I don’t see them altering their behavior. It’s mainly going to alter the deficit. When I think of the payroll tax, at the risk of sounding too cynical, it’s going to basically move forward the date by which Social Security becomes insolvent. There’s only so much that economic policy can do in response to a biological problem.

---

About James Kahn

James Kahn is an independent consultant on macroeconomics and monetary policy based in New York, and a Professor of Economics at Yeshiva University. He has over 11 years of experience at the Federal Reserve Bank of New York, where he was a Vice President, conducting economic research and advising senior bank management on monetary policy and macroeconomic developments in the U.S. and world economy.

---

This article is adapted from GLG’s March 11 teleconference Interpreting the Fed’s Contingency Plan: Fallout from COVID-19. If you would like access to this teleconference or would like to speak with James Kahn, or any of our more than 700,000 experts, contact us.