Fiscal Policy Still MIA

We are still nowhere near the end of this crisis.

As I write tonight, futures markets have limited down again, setting the stage for another ugly Monday morning. A reported factor in the decline is the failure of the Senate to move forward an economic stimulus bill. That may change tomorrow, but even so it must also pass the House where Speaker Nancy Pelosi can advance her own bill. The politics make it difficult to hammer out legislation quickly this week.

That said, perhaps I am being too pessimistic. Legislators have a strong incentive to get the job done given that coronavirus now strikes a little too close to home. Two U.S. House of Representative members have already tested positive and today we learned that Senator Rand Paul has also tested positive. Senators Mitt Romney and Mike Lee self-quarantined on that news, having had close contact with Paul.

Paul apparently made the curious decision to exercise at the Senate gym while awaiting his test results. Which raises the interesting question of why the Senate gym remains open in the first place? Rather than dwelling on those issues, we should instead consider that we don’t seem to find one case in isolation; others inevitably pop up soon thereafter. So one would think that members of Congress, and in particular the older members of Congress like say Mitch McConnell (78 years old), would be eager to wrap this up and maybe engage in a little social distancing.

The delay will hamper the Federal Reserve’s efforts to fight the turmoil in financial markets. Via Bloomberg, the legislation reportedly included funding for the

…Treasury to use $425 billion of the $500 billion “to make loans, loan guarantees, and other investments in support of programs or facilities established by the Board of Governors of the Federal Reserve System for the purpose of providing liquidity to the financial system that supports lending to eligible businesses, states or municipalities.”

This would apparently (unfortunately I don’t have a copy of the proposed legislation) expand the Fed’s ability to create lending facilities to support corporate and municipal debt or even buy such debt outright as they do mortgage backed securities. This would put some considerable firepower behind the Fed’s efforts to unstick financial markets. The sooner the Fed can be more creative, the better.

To be sure, please do not interpret this as criticism of the Federal Reserve. Chair Jerome Powell and his colleagues brought out tools over a two-week span that took years to develop during the last crisis. The Fed has acted with truly impressive speed and I expect it will expand its efforts further. The Fed is not out of ammunition.

That said, the Fed can’t do this job alone and needs the support of fiscal policy. I fear that while we may be temporarily appeased by the initial round of fiscal efforts, Congress and the administration have yet to come to grips with the evolving economic situation. The sudden stop of the U.S. economy is sending unemployment soaring. Initial claims may exceed 2 million this week after state and local governments around the nation began ordering shutdowns of everything except essential services.

My concern is that the fiscal package recommended by the Senate is both too small and too reliant on existing tools to alleviate the damage to household finances and stave off a wave of business closures that would threaten the ability of the economy to bounce back later this year. Other nations are moving much quicker to keep workers on payrolls for an extended period of time. See, for example, the U.K. plan, which pays grants to firms of 80% of salary of employees if companies keep them on the payroll. Moreover, the initial three-month phase would provide some longer-run certainty for firms and employees.

The goal is to keep firms solvent and connected with employees such that the economy can ramp back up after we have some measure of control over the virus (as has happened in China and South Korea, for example). The risk for market participants is the permanent damage to the economy that will occur with insufficient federal support for jobs during this crisis. This is not just another recession; we need bigger and newer tools to mitigate the damage. I am eagerly awaiting the House stimulus plan to see if it moves further than the Senate proposal.

Bottom Line: This week the data will start to catch up to reality and it’s going to be ugly. And beyond that, the coronavirus case load and death count will climb higher; we have only just begun to learn the extent of the spread. We still can’t see to the other side of this, and we can’t yet rely on fiscal policy to support us until we get there. I don’t think this is pessimistic as much as realistic. I have yet to see reason to expect financial markets will stabilize anytime soon.

Go Big Or Go Home

In an effort to keep financial markets from spiraling out of control, the Federal Reserve came out with the big guns Sunday afternoon.This will not prevent the economic downturn that is already upon us. It will, however, create more accommodative financial conditions that will help support the eventual recovery. In the near term, however, the Fed’s action will – hopefully – support smooth functioning in financial markets and ensure that the problems on Wall Street do not feed back onto Main Street. The Federal Reserve has now passed the ball to fiscal policy makers, at least for the time being. This doesn’t mean the Fed is done; Powell & Co. have more ammunition if needed later.

Quick summary of the Fed’s actions today:

  1. Cut policy rates to 0%-0.25%. Back to the zero bound all at once. It was the Fed’s only choice.
  2. Forward guidance. The Fed committed to holding rates near zero “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
  3. Quantitative easing. Federal Reserve Chair Powell didn’t call it quantitative easing, saying instead the label doesn’t matter as long as it gets the job done. Fed will be buying $500 billion of Treasuries (presumably across the curve as the New York Fed signaled last week) and $200 billion of mortgage backed securities.
  4. Discount rate cut to 0.25%. This is kind of a big deal, basically drops the discount rate to the overnight rate to take the stigma out of using the discount window (they really want this stigma gone). Plus, banks can borrow from the window for up to 90 days.
  5. Intraday Credit. Fed wants banks to use its intraday credit programs.
  6. Loan guidance. Fed signals that banks should use their liquidity and capital buffers to lend to household and firms. The Fed is telling banks this is the time to use those buffers.
  7. Reserve requirements. Fed eliminates reserve requirements, which were pretty much irrelevant in a system of ample reserves.

Powell made very clear in the press conference that the Fed’s objective is to support the smooth functioning of financial markets. In particular, the Fed is reacting to the liquidity problems that crept up in the Treasury and MBS markets last week. Powell explained that the Treasury market is the foundation of the global economic financial system and keeping it functioning was the Fed’s primary objective. The MBS market is critical to keep credit flowing to households.

Powell said he expected the second quarter to be very weak but had little confidence in forecasts beyond that. It depends on how the virus evolves. He rightly noted that the rate cuts would not have an immediate impact on the economy, but will support the rebound in activity on the other side. He highlighted the role of fiscal policy in moving targeted aid to individuals and firms directly impacted by social distancing measures. To my ears, he wasn’t yet convinced of the need for a bigger fiscal stimulus, though I think this was because he wasn’t yet confident the downturn would last more than a quarter.

With regards to his own health, he has not been tested for the virus, he feels healthy, and he is doing some teleworking.

The will not be meeting again this week as originally planned. There will not be a Summary of Economic Projections. Powell said the forecasts would be pretty useless right now. And thankfully we then aren’t faced with the prospect of any “hawkish” dots in the 2021 rate forecasts.

Inexplicably, Cleveland Federal Reserve President Loretta Mester dissented against the rate cut, preferring instead just a 50 basis point cut. I await her explanation; I hope it isn’t about “saving ammunition,” which would be pointless argument now. I don’t see much percentage in trying to emulate a Richard Fisher or Thomas Hoenig in this crisis.

The Fed shot a lot of bullets today, but they are not yet out of ammunition. Most of today’s policy moves were designed to support market functioning, not the economy directly. They can do more on both fronts. For example, regarding market functioning, they can expand the size of asset purchases or, if needed, develop 13(3) emergency lending programs. Note that the asset purchases were of a fixed amount. The Fed could switch back to an opened commitment and link it via forward guidance to explicit economic objectives. They can follow up with yield curve control. Then there is the possibility of regime change toward average inflation targeting, etc. That said, in the near term we really need fiscal stimulus. The Fed has paved the way, but they can’t make Congress and President follow their lead.

Financial markets did not exactly cheer the Fed’s move; equity futures limited down, setting the stage for another difficult day on Wall Street.This should not be unexpected. I don’t see the possibility of any near-term stabilization in financial markets until we get more clarity on the challenges we face. This week reality will be settling in as much of the economy is going to be shut down. Testing will expand and the confirmed cases will grow. So too will the number of deaths. I don’t see where the Fed can do much more than keep financial markets functioning in this environment. This is important to sustaining the free flow of credit; crippled credit markets would only make the downside worse. But until we get enough testing, mitigation, and containment to bend the curve, market action will retain that distinctly bearish mood.

Bottom Line: The Fed realized this was a “go big or go home” moment, and it rightly decided to “go big.” The Fed basically signaled as clear as it could that it was ready to backstop the financial markets. I am thinking Powell is not going to let another Lehman Brothers happen on his watch. The Fed can’t, however, keep the economy from diving into a hole in the second quarter. Market sentiment now is probably going be driven by the prospects for fiscal stimulus.

Bad to Worse

This keeps going from bad to worse to even more worse. We cannot get around the simple fact that we lack the cornavirus testing capacity to learn the extent of the challenge in the U.S. and implement effective containment and mitigation strategies. That combined with the abject failure of leadership from the Trump administration to begin to develop a comprehensive humanitarian and economic plan to deal with the crisis increases the likelihood of widespread economic damage in the months ahead.

In a resounding vote of “no confidence” in response to President Donald Trump’s Tuesday night address to the nation,equity markets continued to slide on Wednesday with the S&P500 down 9.5%, the worst day since the 1987 crash. Stocks were only briefly supported by the New York Fed’s announcement of expanded market support to include $1.5 trillion of one- and three-month repo offerings across Wednesday and Thursday as well expanding the range of securities included in the monthly $60 billion reserve asset management program. The Fed has yet to cut interest rates again, but will almost certainly lower rates by the end of next week’s FOMC meeting. They should just take rates to zero and get it over with.

The Fed’s actions were intended to “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak” according to the New York Fed. In other words, they are trying to ensure that the sell-off on Wall Street remains orderly in the sense that market functioning does not become impaired and lead to broad credit contractions. Preventing the turmoil from triggering a systemic crisis is the Fed’s number one goal right now. Eventually, easier policy will support demand more generally, but not until the crisis abates.

Distressingly, futures are red again tonight. It is not realistic to expect the Fed’s action will quickly reverse the slide in equities. The Fed can keep the financial markets functioning, but they can’t make investors buy what they don’t want to buy. Until market participants gain some confidence that they can see the other side of this crisis, they will remain risk averse.

Sadly, we are not yet seeing events that would bolster market confidence and apparently prices have yet to drop to a point where they incorporate all the possible bad news. The most pressing issue is that the virus is out in the wild and time is growing short in many nations to prevent illnesses from overrunning their health care systems as happened in Italy.

The rising acceptance of social distancing measures is a promising sign with corporations and sporting leagues taking the early and bold steps. State and local efforts are lagging. The slow decisions to close schools, for example, may prove disastrous in many communities. As Italy and Wuhan have proved, letting the problem fester only raises the overall costs of responding to the virus.

Markets may get some relief from fiscal policy, but I wouldn’t anticipate sustained gains just yet. The administration continues to dither while House Democrats push forward a fiscal policy response. Some combination of paid sick leave, increased unemployment benefits, Medicaid funding, and free testing appears to be in the works; we don’t yet know what will be acceptable to the Senate and the White House. This is likely to be only the initial package; I suspect (hope?) more direct cash aids to households will be coming.

Bottom Line: At the moment, market participants can’t see beyond the immediate crisis and continue react rationally to the flow of bad news. The Federal Reserve will do what it can to support markets and the economy – it’s the only game in town at the moment – but we all know it in the longer term it is playing a supporting role. The leading role falls to the fiscal authorities to craft a response to the humanitarian crisis and the economic cost. So far, the response has been woefully lacking. 

The Beatings Will Continue Until Morale Improves

Markets are in motion overnight as we go into what promises to be another wild week. The coronavirus remains the focus of everyone’s attention, and for good reason. Unfortunately, the bad news seems likely to keep coming this week as testing ramps up in the U.S. In this environment, there seems to be little hope to expect stability in financial markets.

The blackout period ahead of next week’s FOMC meeting leaves us with no new planned guidance from the Federal Reserve. The expectation among market participants is that another big rate cut is coming. Strained credit markets will bring the Fed to the table more quickly. Given what is happening overnight, Monday morning the Fed could be pulled back into action.

The novel coronavirus Covid-19 is out in the wild; containment seems to be a long-lost hope. In the near term, we are hoping to suppress the pace of spread of the virus and limit the strain on medical resources. “Social distancing” will be the new norm for the next several weeks, the costs of which will fall most heavily on travel and tourism. For example, persons at most risk are now being advised to avoid large groups, long trips, and cruise ships. People will be encouraged (or ordered by employers) to work from home when possible. We will see more school closures. The University of Washington and Stanford University both closed campuses. This will likely be a theme this week

As testing kits become more available, the number of confirmed cases in the U.S. is likely to climb. This will be something of a double-edged sword. In the near-term, the rising numbers will fuel additional fear and uncertainty. But, over the longer-term, we can’t start thinking about the other side of this until we get a better handle on the size and scope of the challenge. 

Until we can see the other side, there will be a rational tendency to focus on worst case scenarios. That implies the theme of risk aversion will continue. Stock rallies will be short-lived and market participants will lean toward safe assets – as evidenced by the fall in 10 year treasury yields to 0.5% Sunday night.

Markets are not looking good Sunday evening. Stock futures are off sharply; equities might open down in more than 4% Monday morning. Oil prices have collapsed, down a staggering 30% as Saudi Arabia meets weak demand with a price war. Note that this has mixed effects on the U.S. economy. Lower oil prices are good for consumers but will hammer energy producing regions and highlight credit risk in the sector.

Market participants clearly expect considerable economic pain in the months ahead. To be sure, we don’t how much of the action right now is overshooting. Memories of the last financial crisis run very, very deep and as a consequence market participants could be prone to excessive panic. Still, even if excessive, such panic can have very real consequences if credit markets begin to freeze. The Fed needs to be ahead of worsening problems in credit markets to prevent panic from becoming a reality.

The Fed may have to act again before the next meeting, like Monday morning. Although last week some Fed officials like St. Louis Federal Reserve President James Bullard floated the idea that the Fed simply moved up the March rate hike, such comments shouldn’t be taken too seriously (the blackout period couldn’t come soon enough).

There is just too much uncertainty for the Fed to try to hold off on further easing and a strong argument for delivering more easing sooner than later. Given low inflation low and market expectation that it falls further, the low-risk, high-reward policy position argues in favor of additional easing.

Realistically, the Fed should be discussing just taking rates to zero and getting very far out ahead of the data but they tend not to react that quickly. Bond markets are telling them to do it. I don’t have a strong argument for gradualism in this environment. If you take rates to zero, you maximize the odds of getting ahead of the weakness. If you can’t get ahead of the weakness, you are going to zero anyways. In either case, once you get back to the zero bound, then you need to look at QE, yield curve control, forward guidance, liquidity provisions, etc.

It would help greatly if the Federal government could pull together a fiscal rescue package sooner than later. Or at least look like they have a grip on the evolving situation. Good luck with that; we were lucky to the meager funds of last week. Sad to say, the Federal Reserve remains the only game in town.

Is there any good news? Yes. The U.S. economy was entering this crisis with some momentum as evidenced by a number of indicators including the March employment report. In addition, manufacturing had been firming and the housing market was set to make further gains. On housing, the demographics are in our favor and the market will be given a boost by lower mortgage rates. Those lower rates are also driving a refinancing boom and thus are providing additional support to the economy. 

All of this will matter on the other side. But no one cares right now. Even if we know there is another side to the crisis, we still can’t fully judge the depth and length disruption ahead of us. Anyway you cut it, the near term is ugly.

Bottom Line: As testing ramps up in the U.S. this week, so too will the number of confirmed cases. With more confirmed cases will come more disruptions. Lacking any clarity, fear remains the dominant financial market theme. If the Fed learned anything from 2007-09, they need to go big and go fast if there are even hints of credit market disruptions. That should drag them into action sooner than later. More rate cuts and/or liquidity measures to maintain market functioning could come very soon if not Monday morning.

Bullard Tries To Pull Back Rate Cut Expectations

A couple of quick items tonight.

First, yesterday’s Bloomberg Opinion column:

Financial markets met Tuesday’s emergency interest-rate cut with a fresh wave of equity selling and bond buying. This probably wasn’t the reaction Federal Reserve Chair Jerome Powell was hoping for. Did the central bank just make things worse? This probably isn’t the right way to think about the current situation…

Second, St. Louis Federal Reserve President James Bullard tried to throw some cold water on rate cut expectations. Via Bloomberg:

“It’s unlikely we are going to have that much different of information when we get to the March meeting,” he said Wednesday. “I am not sure you should put a lot of weight on the March meeting right now.”

Bullard is saying that we got the March rate cut early and we should be happy about that and not expect something more. I wouldn’t take too much stock in Bullard. Clearly, it doesn’t take much imagination to see another wave of bad news coming down the pipeline in the next couple of weeks. The number of Covid-19 cases are certainly go to rise, there will be school and workplace closures, etc. Travel and tourism will certainly be impacted. That said, we should be on the watch for similar comments by other Fed speakers. I think such comments would be injudicious given the evolving situation.

Third, a refinancing boom is underway, also via Bloomberg:

A drop in interest rates in response to the coronavirus outbreak is adding urgency to a hiring spree across the mortgage industry.

Executives at four of the nation’s 15 biggest mortgage lenders, already gearing up for a busy 2020, anticipate hiring thousands of employees this year to keep up with what they expect to be a flood of demand for purchase loans and refinancings.

Refinancing will help support consumption and lower rates will support the housing market in general. A bit of economic good news amongst the gloom.

That’s it for tonight!

Fed Can’t Solve This Alone

Despite the Federal Reserve’s 50 basis point emergency rate cut, equities could not build on Monday’s rally and instead crumbled. The allure of safe assets could not be beat as the 10-year treasury yield slipped below 1%. Financial markets will continue to struggle until market participants gain some clarity on the economic implications of the outlook. Fed rate cuts will be a necessity during this period, but won’t be a magic bullet. This crisis will take some time to work through. The less competent the federal response, the more time it will take.

The Fed’s statement was short and to the point. Policy makers decided that the coronavirus presented “evolving risks to economic activity” and justified a rate cut despite strong economic fundamentals. In the also-short press conference, Chairman Jerome Powell noted supply chain and travel-related challenges. The spread of the virus in U.S. cities made further disruptions more likely. A rapid response was judged appropriate.

The Fed’s rapid response reveals the extent of its evolution over the past year. Powell’s Fed has a heightened concerned about the risk of recession. With inflation still low – and too low in the eyes of some Fed officials – the Fed sees little downside risk to acting early and substantial potential upside reward. If early action short-circuits the development of recessionary dynamics, then they may squeeze through this episode without returning to the zero bound.

Financial market participants did not appear to find the Fed’s actions calming. Still, the action may not have reflected disappointment with the Fed. It is reasonable to believe that Monday’s rally reflected the anticipation of the Fed rate cut and with that cut in hand market participants re-positioned and shifted focus back on the economic implications of the coronavirus.

I suspect we will see that story play out more than once in the days ahead. We still seem to be a long way from having any clarity on the extent of the crisis. And the clarity we are getting so far isn’t all that encouraging. It appears that federal authorities bumbled the initial response with limited testing activity. The virus may have been circulating for weeks, undetected because no one was looking for it. Consequently, containment will be more difficult than would be the case with early and aggressive testing.

Considering the unknowns, market participants will tend to focus on the more severe of the potential outcomes. The sharp drop now being reported in Chinese manufacturing activity is not so much a surprise given the extent of the closures but still helps bring the downside into focus. Is that what is in store for the U.S.? We don’t know. What we do know is that incoming news is likely to be more depressing than not.

Given the lack of clarity, a risk-on environment will not come on the back of rate cuts alone. Easier policy is needed to support financial market function and create the accommodation that will support a return to activity when the crisis ends. But it might not diminish risk aversion in the near term. For the time being, we may be a in a one-step forward, twos-steps back phase of market reactions to news and policy.

Eventually, that will shift back to two-steps forward, one-step back. There will be another side to this crisis. We just can’t see it yet. If you are looking for some optimism, Bloomberg reports that rising pollution levels in China indicate the country is getting back to work.

Bottom Line: The Fed will deliver more rate cuts in the weeks ahead. Just because they are not met with immediate market gains doesn’t mean they aren’t necessary or won’t be effective in supporting the economy. In the near-term, the negative news flow and lack of clarity on the outlook will tend to depress risk appetites and thus market participants may not react as jubilantly to Fed policy moves as they might in a different economic environment.

Another Ugly Week Ahead?

Equity futures fluctuated overnight as market participants continue to grapple with the implications of the spreading Covid-19 virus and the anticipated policy responses.Unabated selling will eventually be met with Federal Reserve rate cuts. Given that we are in uncharted territory, we don’t know when those rate cuts will come. The Fed would prefer to hold off until the March meeting in just over two weeks, but a rate cut could come as early as Monday morning.

With new cases appearing in multiple U.S. states, it appears the community spread of the virus is underway. It is possible that it has already been spreading in Washington state for as long as six weeks. With testing ramping up this week, we should expect more confirmed cases. And, sadly, more fatalities attributed to the virus.

It appears that we are going to have to learn to live with this new virus and take rational measures to slow its spread. Schools will be closed, people will be asked to work from home if possible, travel will be curtailed, etc. We can expect more severe reactions and restrictions early on in the process as we assess the relative costs and benefit of various responses. Given the unknown costs, we should expect institutions to err on the side of overreaction for the time being.

The Fed is poised to cut rates, a stance made clear by last Friday’s statement. The ultimate amount of easing depends obviously on the economic outlook. Clearly the greater the extent of the disruption to normal life, the greater the economic cost and the greater the magnitude of the Fed’s action. Economists in the U.S. are busy slashing forecasts in anticipation that activity will slow substantially in the next six months. Goldman Sachs now anticipates 0% and 1% growth in Q2 and Q3, respectively. They also expect a 50bp Fed rate cut in March and another 50bp later in the year

A full percentage point of rate cuts is not unreasonable estimate, but given the rush to re-evaluate the outlook in light of last week’s market meltdown, they may prove consistent with only an overly pessimistic outlook.We just don’t know what portion, if any, of recent market moves are excessive because we don’t know yet how much the economic impact of the virus resembles that of a natural disaster. That said, there also exists the scenario in which more recessionary type-dynamics develop and push the Fed to take rates back to zero.

The question at this point is the timing and magnitude. The timing could be anytime between now and the March 17-18 FOMC meeting; it seems evident that the Fed could easily be forced by financial markets to act sooner – like this morning – rather than later.

I can see where the Fed will continue to hesitate to cut interest rates; they still may want to wait until there regularly scheduled meeting rather than appearing to panic and rush into a rate cut. In addition, central bankers may at least initially focus on the supply-side impact and be concerned that they don’t want to waste a policy response more suited for a demand-side shock. I don’t believe the Fed could use this argument indefinitely to avoid a rate cut, but in the near-term it might induce the Fed inclined to focus on credit market implications more directly if possible. It may be that the Fed’s first response is directed toward market functioning such as expanded repo operations.

Bottom Line: Lots of moving pieces here. The Fed now seems likely to cut rates at least 25bp by the middle of the month. As of tonight, the odds are tilted toward 50bp and sooner. I don’t know that we have a lot of idea about what the Fed is thinking exactly. Powell and his colleagues have really given us very little to work with. The reasonable assumption is that a rate cut is the first option We should consider the possibility that another credit market-specific tool is involved.

Yes, Monetary Policy Can Still Be Effective

Short reminder:

I have seen considerable commentary that the Fed can’t do anything because the virus is a supply-shock and the Fed only has demand-side tools. This ignores that the nature of this supply-side shock produces a demand-side shock at agents delay spending or if the flow of credit from financial markets becomes impair. Hence the Fed does have a role to play here.

Worth reading is this short paper by Christina D. Romer and David H. Romer:

It is widely agreed that this record is far from perfect, and that there have been some major failures of monetary policy over the past century…In this paper, we present evidence that an unduly pessimistic view of what monetary policy can accomplish has been a more important source of policy errors and poor outcomes over the history of the Federal Reserve.

Paper here.

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.

This Is Going to Take Some Time to Play Out

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.