Well, That Didn’t Work

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.