President Donald Trump couldn’t calm flailing markets. Now it’s Federal Reserve Chair Jerome Powell’s chance to give it a try.

The situation continued to worsen yesterday as virus-related concerns rocked financial markets again, plunging the S&P500 back to levels of last October. The market response is not unreasonable. The magnitude, both in terms of human and economic costs, of an outbreak in the U.S. remains very uncertain. It is not a surprise that market participants should fall into the “sell first, ask questions later” mode.

The Fed has a clear role to play in the current situation. This is not just about a supply-side shock. This is now about preventing the soft-patch on the demand-side of the economy from becoming a recession. That requires maintaining confidence among households. And, like or not, that requires putting a circuit breaker on Wall Street.

The Fed can’t let runaway selling on Wall Street like we have seen this week continue and shake confidence on Main Street. Eventually they have to step in and act.They don’t have to cut rates now, or even cut rates in March. What they need to do is make clear they are prepared to cut rates much as Federal Reserve Chair Jerome Powell did last June with his “act as appropriate to sustain the expansion” comments. The timing and the tone are what matters in these situations.

If Fed speakers today continue to come out with the unified message we have recently seen from central bankers across the globe – essentially, “it’s too early to say anything” – they risk aggravating the selling on Wall Street and worsening the public’s confidence in the economy.Instead, they need to come out with a much more dovish tone, signaling that they clearly see what is happening and are prepared to act. That will buy time for market fears to be realized or not before the Fed needs to make a decision on rate cuts.

Better yet, someone like Vice Chair Richard Clarida, or Powell himself, should give step in front of the cameras unexpectedly and offer a soothing message. That message would be heard.

I understand why the Fed is trying to avoid encouraging the idea that a rate cut is coming. The current fears may turn out to be overblown; there may be minimal or very limited economic disruption. It might be a hard couple of months of weak activity, but it will be followed by return to normalcy, much like is typically experienced after a natural disaster.

But current fears could be more or less justified. The U.S. might be headed for recession. Consider the example of 1991. The U.S. economy stumbled into 1991 weakened by tighter monetary policy and the savings and loans crisis. It only took one shock to end the expansion, and that shock was the war in Iraq and the associated spike in oil prices. You might think of that as a purely supply-side shock, but household spending suddenly retreated, tipping the economy into recession.

The current situation is similar. The economy entered the year on a soft note, but looked to be recovering. The virus outbreak is a supply-side shock like an oil price spike, but also produces demand-side weakness.

If households just delay spending for a few weeks as they assess the level of threat and then life reverts to normal, we will see only a soft-patch in the data. The longer consumers stay on the sidelines, the higher the probability that the negative impacts on the economy become self-reinforcing, and the greater the possibility that the soft-patch becomes a recession. A continuing panic on Wall Street only makes the latter outcome more likely.

The Fed still has a job to do. That means maintaining confidence in the economy, which in turn means saving Wall Street from its own worst fears.

I will start with the good news.

Just kidding. There is no good news.

Equity markets across the globe continued to slide as market participants react to the spread of the Covid-19 coronavirus. The S&P500 ended the day down just 0.38%, but realistically, further declines should be expected.Sadly, recent declines only take the S&P500 back down to average in my simple but so far fairly reliable tracking model:

In other words, it hasn’t really gotten interesting yet. The tape bombs are not going to stop anytime soon at this point. The virus looks like it is out in the wild in the U.S. now that we have a case in Northern California with no apparent direct connection to the outbreak. To be sure, this had already seemed inevitable earlier this week. The fact that many patients have no to mild symptoms means that it may have been circulating for many days yet been undetected. It seems likely that we will hear more such stories in the weeks ahead.

We are now heading into the unknown. Much now depends on how severe the outbreaks become and how much they disrupt the ordinary business of life. This in turn depends on the effectiveness of public health authorities to both manage the outbreak and maintain a sense of calm and normalcy.

Early signs are not good. Equity futures fell in the hours after President Donald Trump’s press conference today. Not exactly a vote of confidence. Market participants should recognize the danger of a government run by people who don’t believe in government. Such a government may do little short-run harm in the absence of a crisis. During a crisis, however, the incompetence of such a government becomes all too evident.

The best-case scenario is that a few hotspots of contagion appear, they are quickly isolated with minimal disruption and then warmer weather arrives and with it the natural dissipation of seasonally illnesses. On the other end of the spectrum is a more severe outbreak and the associated disruptions in activity as witnessed in China.

Hope for the best, plan for the worst. At the moment, market participants are beginning to plan for the worst.

U.S. treasury rates have descended as market participants prod the Fed to take action in the form of easier policy. The short end of the yield curve has inverted but the longer end has yet to follow suit:

My interpretation of this pattern is that market participants still believe the Fed can prevent a recession with two to three rate cuts. The Fed, however, is not inclined to move quickly. Nor are other central banks. The Bank of Korea, for instance, surprised by holding rates constant despite the growing number of cases in the nation. It seems that central banks are largely trying to treat the threat of the virus as if they would any other natural disaster. They may be able to do so if concerns soon ease. The longer the virus disrupts activity, however, the less tenable that position will be.

Bottom Line: For the time being, the Covid-19 virus will dominate headlines. It will depress activity in the short run. We don’t know how long the short-run will last, nor do we know what trip wires we may hit along the way.

P.S. New home sales climbed in January, reaching their highest level since 2007. There remains some fundamental momentum in this economy, but that momentum will remain hidden under the virus news in the near-term.

Still uncertain about the magnitude or persistence of any negative economic shock, the Fed resists a coronavirus-induced rate cut. Unless credit markets stumble more severely, it will try to delay a cut until justified by the data.There will be skeptics about the efficacy of a rate cut. Don’t make the mistake of thinking that a Fed rate cut won’t have a positive impact on the economy. Fed inaction would only worsen the outlook.

In the wake of this week’s turmoil market participants are now pricing in at least two rate cuts for this year. A wide range of Federal Reserve officials, however, have pushed back on the idea that they are poised to cut interest rates this year. The latest was Fed Vice Chair Richard Clarida, who today said “…it is still too soon to even speculate about either the size or the persistence of these effects, or whether they will lead to a material change in the outlook”

This is completely unsurprising. Fed officials are naturally inclined to embrace the “temporary shock” scenario.The Fed positioned itself to leave rates unchanged for the year given that the economy had regained its footing. The Fed will worry that the fears evident in the markets this week will ebb as quickly as they swelled, leaving them in a position of having cut rates unnecessarily and just ahead of a large inventory correction phase for the global economy. In addition, the Fed may view the stock market declines as expected given concerns that asset prices had become elevated.

Consequently, we are in a familiar place. Market participants and the Fed are on a collision course. Typically, market participants win that game. It often takes time for the Fed to get there, but once they do, they move quickly. They will move more quickly if they perceive that credit markets are at risk of tightening substantially, so watch that space. Otherwise, they will be watching the data flow.

Realistically, the Fed will eventually need to fall in line with market expectations.The ongoing anxiety about the virus and its potential impacts looks likely to continue for the time being and the longer it continues, the greater the negative impact on activity. Absent a rapid reversal of recent events, Fed will eventually need to provide some cushion for markets and the economy.

But would a Fed rate cut even do any good? After all, the primary concern is the potential disruption to the supply side of the economy. The Fed can’t restart factories. The Fed can’t make a vaccine. And on the demand side, the Fed can’t make people spend if they are too scared to leave their homes.

I don’t believe this would be a dominant view holding back Fed action should the economy or markets stumble meaningfully.The Fed can certainly help prevent the financial sector from choking off the economy even further. Falling long term yields suggest the neutral rate of interest, at least for the near term, is falling. To just hold financial accommodation neutral, the Fed needs to react by reducing policy rates. Failure to do so would lead to tighter financial conditions and worsen any coronavirus induced downturn.

In addition, the Fed can short-circuit panic on Wall Street and in turn prevent that panic from spreading to Main Street.If the populace becomes more concerned about the potential impacts of the virus, those concerns would only be heightened by crashing markets or a sharp contraction of credit. Fed easing to support financial markets would be essential to prevent such a chain of events.

Bottom Line: All told, we are in a familiar place. The Fed wants more information before acting, while market participants have already decided action will be forthcoming. The Fed still hopes there is a reasonable chance that market participants reverse their bets before too long and hence is prepared to bide its time. Be prepared that the Fed will likely continue to shrug off market concerns without seeing a more imminent threat but that per usual when they move, they will move quickly. Also be prepared for easing to have a positive impact should the Fed decide it is needed.

I have been a bit under the radar lately. Largely due to an excess of University-related work and partly because conditions had turned somewhat boring, being neither boom nor bust. Fairly unexciting near trend growth.

Conditions are no longer boring.

Still, I hesitate to comment. I am not an epidemiologist. I am also not prone to panic, a trait which doesn’t match well with the current mood. I am not inclined to play the game of ramping up the hysteria. Moreover, this is a low-information environment, making any comment risky and vulnerable to being overtaken by events.

All that said, this is how I am thinking about the current state of play:

The basic situation can be quickly summarized. Efforts to contain the virus have substantially disrupted the Chinese economy. This disruption quickly spills into the global economy due to the reliance on Chinese manufacturing in the global supply chain. Containment efforts also severely impacts the travel and tourism industry. The longer the containment continues, the more damage the global economy will suffer.

In theory that damage should be largely temporary. Once containment ends – presumably with the threat of contagion ebbs – we would expect a substantial push to rebuild inventories. That gives rise to the V-shaped recovery scenarios.

This story works reasonably well if the virus can be contained. Worrisomely, this may not be the case. Outbreaks in Italy, Iran, and South Korea, for example, reveal it spreading; the Italian situation is especially worrisome given they authorities reportedly can’t track down the original source of the local infection. The World Health Organization already worries that the virus can no longer be contained.

If containment fails, that failure would likely be attributed to an initially slow response in China and the nature of the disease. According to reports, for many the virus has mild symptoms or the carrier may be asymptomatic. The virus could already be spread much farther than we realize. On the upside though, the mortality rate might then be much lower.

I am happy to be wrong on this (remember, not an epidemiologist), but I am working on the assumption that this virus is now out in the wild and can no longer be contained. If so, we will need to adapt to it as we have to other seasonal illnesses.

While that may be my base case, that isn’t necessarily yet the base case of public health authorities. As long as the focus remains on containment, and the virus continues to spread, we should expect further disruptions to the global economy. Containment – travel restrictions, closure of public spaces and factories, etc. – is costly. More containment efforts will yield greater economic and social costs.

The extended and rolling nature of containment efforts appears to be the greatest concern of market participants.That concern was likely the proximate cause of Monday’s market action. I think we should keep in mind though that, at some point, the economic and social costs of containment become too much to bear. There is only so long authorities will be able to hold the global economy hostage for a virus that can no longer be contained and has a potentially fairly low death rate. At some point, the focus shifts from containment to mitigation (good thread here), supply chains come back to life, and the inventory correction begins.

If containment is still possible, but takes longer than expected, then the V-recovery becomes a U-recovery.The longer it takes to shift from containment to mitigation, the wider the base of the “U” and the higher the chance that the bottom of the “U” is a recession. In any scenario, I would expect persistent weakness in travel and tourism activity. It seems reasonable to expect international travel, particularly to Asia, to be depressed until people become more familiar with the nature of the virus (I am still assuming it is out in the wild).

In either case then – containment or mitigation – what this comes down to is a waiting game.How long until the virus is contained? How long until authorities shift to mitigation? I would assume that one of these two outcomes happen by the end of the second quarter. Either the warmer weather helps reduce the pace of new infections, or the ongoing containment efforts become too costly, or some combination of the two.

To be sure though, this is all guesswork. Clearly, we have limited information to work with. I don’t know how an admission that mitigation is the option will be met by a public already fed a daily death rate. Will they panic? Or take it in stride? The risk in either containment or mitigation in the U.S. is that the process is completely botched by the Trump administration. Early signs are not encouraging.

Federal Reserve officials are likely asking many of the same questions. Until the last few weeks, it was evident that the economy was on the mend. They were comfortable holding rates at current levels for the foreseeable future. They are not prone to rapid policy shifts and the equity decline has yet to be of a magnitude to justify concern. Indeed, I suspect that many will believe equities were a bit frothy and set for decline anyways. A credit event, however, would likely get the attention of policy makers. They won’t want to cut rates too soon and then immediately see the pace of new infections quickly diminish and an inventory correction occur suddenly. Some officials may even question the usefulness of a rate cut in the face of a supply side shock.

Bottom Line: This is a low information environment. We don’t know how long this virus issue will be with us. The uncertainty will leave us susceptible to panic. Best case scenario is obviously that the virus subsides soon. If it doesn’t subside soon and instead the spread widens, the next best scenario is that the shift from containment to mitigation happens sooner than later. My baseline scenario lies on the mitigation part of the continuum (does this make me an optimist or a pessimist?). I don’t see that authorities will let the global economy collapse with ongoing containment efforts if the virus is already out in the wild. That said, I also cannot ignore the possibility of a more pessimistic outcome. Fed will bide its time absent a credit event or signs the economic foundation is weakening.

The employment report yielded an upside surprise in payroll growth but still low wage growth argued that labor markets have yet to overheat. It’s the kind of report that will support optimism at the Fed without raising concerns that policy rates need to be pushed higher. The Fed will instead remain poised to react to any emergent threats to the economy with rate cuts if needed. Separately, the search for repo solutions continues.

Nonfarm payrolls grew by a better-than-expected 225k for the month and and a monthly average of 211k for the past three months:

Although revisions dragged down 2019 numbers overall, it appears that job growth picked up later in the year. Note though that warm weather may have boosted January figures and as such we may see some payback in February. The unemployment rates held in its recent range at 3,6%, still well below the Fed’s estimate of the longer-run natural rate of unemployment:

Needless to say, the failure of inflation to ignite with persistently  low unemployment suggests the Fed will be again lowering estimates of the natural rate this year.

Wage growth remains off its peak:

It is important to remember that adjusted for inflation, wage growth remains in-line with productivity growth. That said, low wage growth also suggests that the labor market is not overheating. Unless the labor market is overheating, it is difficult to see how any uptick of inflation can be sustained. Increased participation in the labor market helps account for contained wage growth:

So far, fears that the economy will run out of workers overall have yet to be realized. One sector that might be feeling the pinch is temporary employment:

Employment growth in the temporary employment sector is not collapsing as we might expect ahead of a recession, but neither is it booming. To be sure, the recent weakness is attributable at least in part to manufacturing softness like in the 2015/6 era. But the failure to get much upward momentum despite solid job growth otherwise might reflect the availability of better, permanent jobs in other sectors. This is consistent with the idea any current labor market supply constraints remain sector or geographic specific and not reflective of broad constraints.

Overall, the employment report suggests the U.S. economy continues to grind forward with perhaps not the most exciting pace of growth but steady growth nonetheless. The Fed won’t be itching to raise rates anytime soon with these numbers.

Separately, Federal Reserve Governor Randal Quarles gave a wide-ranging speech on the economy. Importantly, Quarles’s thinks the labor market has more room to run:

I am in the camp that believes that some additional slack remains in the market, particularly in the potential for higher labor force participation.

Still, his optimism is tempered by recent events:

Although I feel good about the outlook, a few developments give me pause. Significantly, investment continues to be weak, declining over the course of 2019. Increasing the capital stock and investing in new technologies are important for productivity growth, rising living standards, and the economy’s long-run growth rate, so reversing the recent downward trend is essential for the overall health of the economy.

He cites weak global growth and trade disputes as well as the impacts of the coronavirus as  factors weighing on the outlook. Quarles overall conclusion:

In summary, I remain optimistic about the outlook, but I am also highly aware that some notable risks still threaten growth, both overseas and at home.

Still then looking for downside risks. On inflation, Quarles indicated a lack of concern with the recent low numbers:

A few words on inflation. Both headline and core inflation, as measured by the price index for personal consumption expenditures, or PCE, came in at 1.6 percent in December, somewhat below the FOMC’s 2 percent objective. This deviation does not worry me that much, in part because I expect inflation to move back to target over the medium term, in part as some unusually low readings in early 2019 pass out of the data. Already, various trimmed price indexes are running much closer to 2 percent.

This is interesting and I wonder that Quarles is pushing back on the idea that the Fed will lower rates later this year to push inflation higher. Overall, he sticks with the party line as far as interest rate policy is concerned:

Policy is in a good place to support continued economic growth, strong labor market conditions, and inflation returning to target.

Quarles turns his attention to recent repo market problems and how they relate to the balance sheet. There is a lot going on in this paragraph:

Taking stock, I note that one approach to the constraints on policy imposed by the current low level of interest rates is to make what were previously unconventional tools—balance sheet policies and forward guidance—as conventional as possible. Although I fully support the FOMC’s current plan to purchase Treasury bills and increase the size of the balance sheet in the very short term, over the longer-term, I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion. In effect, I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed’s asset holdings.

When Quarles describes shrinking the balance sheet relative to GDP, this can be an active or passive shrinking, as least in theory. The Fed could simply allow the economy to grow into the balance sheet. One gets the sense that Quarles is seeking a more active approach when he says “meaningfully.” That sounds like a combination of time and quantity; it’s not “meaningful” if done slowly because of the last sentence in which Quarles thinks the balance sheet policies are more credible if not associated with a persistent increase in the size of the balance sheet.

I am not entirely clear why Quarles thinks balance sheet policy is more credible if it is seen as temporary policies. I feel like we have been down this road and concluded that the signaling the temporary nature of quantitative easing reinforced expectations of tighter policy in the future that translated into tighter policy today.

Quarles, in a pursuit of minimizing the size of the balance sheet, appears to want to touch the hot stove again:

Looking ahead, I judge that it is reasonable that we ask ourselves whether it may be possible to operate with a lower level of reserves and remain consistent with the ample framework.

To accomplish this, he proposes making Treasury holdings and reserves more similar (both are high quality liquid assets but reserves are more available). He argues that this fits with the Fed’s original mission:

Yet it is worth remembering that a principal reason for the Federal Reserve’s creation was to facilitate the movement of reserves when needed from banks with an excess reserve position to those in need of reserves. Indeed, it is the reason we are called the Federal Reserve. I do not think that is a fact of purely historical interest. Excessive friction in the movement of cash in the financial system was likely a contributor to the market dislocations of last September. In that regard, I think it is worth considering whether financial system efficiency may be improved if reserves and Treasury securities’ liquidity characteristics were regarded as more similar than they are today—that is to say, that reserves and Treasury securities were more easily substitutable in the context of liquidity buffers. To be clear, the ideas I will discuss do not involve any decrease in banks’ liquidity buffers. Rather, I want to explore options that would maintain at least the level of resilience today while also facilitating the use of HQLA beyond reserves to meet the immediate liquidity needs projected in banks’ stress scenarios.

He suggests allowing banks to assume the use of the discount window as part of their liquidity planning, an approach that has the benefit of using existing facilities. Something along these lines appears to be his primary focus. He half-heartedly suggests a standing repo facility but he prefers to working with existing tools first. A third suggestions is to alter the calculation of the surcharge for systemically important banks to something less dependent on year-end inputs in favor of averages for these inputs.

I takeaway is that Quarles would like to further reduce any discount window stigma and rely on that to again push the on the boundary of the adequate level of reserves. Seems unnecessarily risky to me.

Bottom Line: Employment report supports an outlook of cautious optimism. No reason to think the Fed needs to switch gears anytime soon, and if they do switch gears it is still more likely down than up with rates. Watch the talk about inflation; not everyone is worried about the low numbers. The Fed is still feeling around for answers to the repo market problems; not all believe that expanding the balance sheet is best approach to those issues.

Coming up this Friday is the jobs report for January. In addition to the usual items of interest – payroll growth, unemployment, wages, labor force participation – we also get revisions for last year. The revisions are in some sense old news; we know employment will be revised downward and reveal that 2019 job growth was less than initially reported. The bears will focus on the revisions, but I think it is wiser to keep attention on the January numbers and what they tell us about the upcoming year. We are looking for a report that is both consistent with firming economic indicators this week yet gives no hint that the Fed needs to rethink its current dovish policy stance.

We have seen plenty of questioning about the durability of the equity rebound since last fall:

I tend to think the rebound is not surprising given how events have unfolded in the past six months. The Fed cut rates a third time and signaled no hikes are likely in 2020 (if not the rest of the cycle), the housing market has clearly recovered from the 2018/19 soft spot, global manufacturing firmed, and trade concerns were moved to the back burner. Moreover, there was always an excessive emphasis on the manufacturing data while ignoring the declining importance of that sector.

The short version is that the odds of recession dropped precipitously in the last quarter of 2019 and markets reacted as expected. And the data increasingly confirms the more optimistic scenario of this year. The ISM manufacturing index climbed back above 50, reverting toward the already more positive Markit reports:

Notice the international side of the report, with both rising import and export numbers:

I tend to think the import numbers are more important as they reflect stronger domestic demand. The ISM service sector numbers also improved:

Note that the service side of the economy never softened as much as the manufacturing side. The pattern is not dissimilar from 2015/16:

Will the January employment report also tell a story of firming economic activity? Today’s ADP report clearly provides reason for optimism with is 291k private sector job gain. Using that as one of the inputs into a simple forecast yields an expectation for job growth of 218k in January:

That feels high to me; Wall Street is looking for a more modest 160k. Continued job growth along that more modest pace, however, would still indicate that the US economy has the momentum heading into 2020 consistent at least with growth around trend, which is what the Fed is looking for to support their current forecast.

But job growth is not all the Fed is looking for. They are also looking to confirm their current belief that the U.S. economy is not set to overheat and send inflation to an unacceptably higher level. It’s not enough to just look at the unemployment rate on this issue anymore. The unemployment rate has held below the Fed’s estimates of the natural rate of unemployment for over three years yet inflation remains at bay.

At some point, if for example, unemployment slipped further to 3%, the Fed might become more worried that the economy will overheat if they don’t act to tighten policy, but right now this is not the case. Powell & Co. instead are willing to sit on the sidelines as long as inflation remains close to their 2% target. Continued weak wage growth would help keep them there. While strong wage growth does not necessarily imply high inflation, it is difficult to see that higher inflation could be self-sustaining absent corresponding wage growth.

Bottom Line: So far the economy is firming as expected with no sign that inflation will accelerate to a worrisome pace. Continued evidence of such a trend will keep the Fed on hold. And if they were to shift policy, the Fed would more likely cut rates to boost inflation higher than raise rates. To be sure, the random negative shock (think coronavirus) always lingers in the background. At the moment though, a firming economy with inflation low enough to keep the Fed focused on steady to easier policy is the best bet.