There are no perfect analogies for the current coronavirus outbreak. But there are striking similarities with the past.
SARS hit in 2003 as the U.S. was continuing to recover from the "tech wreck" and imminently invading Iraq. The Greenspan Fed was struggling to get inflation to its 2% target and inflation expectations were falling. The Federal Open Market Committee slashed the fed funds rate to 1.25% to stave off a further contraction in economic activity or inflation.
The economic hit from the 2019 escalation of the U.S.-China trade war and the combination of the Iraq War and popping of the tech bubble are noteworthy in the similarity. Manufacturing was struggling in 2003 and 2019. SARS and the manufacturing slowdown knocked realized and expected inflation lower. There were nascent signs of a global recovery, but nothing that was convincing. SARS and the coronavirus have starting points that rhyme.
There is one important distinction between the current scenario and the SARS episode, however. About 3 months after SARS hit the newswires, the Fed took out its final rate cut of the post-tech-wreck era, moving fed funds lower by 0.25%.
“So what I want to put on the table at this stage, and I hope it’s acceptable, is to move the funds rate down 25 basis points… continue to imply that the risks of igniting inflation are very low.” That was FOMC Chair Alan Greenspan at the June 2003 meeting. That could easily be from the current FOMC meeting or the next. In fact, it does not sound all that dissimilar to the current soundbites coming from the Fed - aside from the 0.25% rate cut.
In the 2003 episode, inflation expectations declined from 2% (the Fed's internal target) to about 1.5% bottoming almost coincidental to the final insurance cut in June. For its part, realized inflation remained mired well below target for the remainder of 2003 and the first half of 2004.
But it should not be ignored that the Fed actually "pulled it off". The insurance rate cut achieved its desired goal of stabilizing inflation expectations and quelling disinflation fears. It convinced markets Fed was not going to accept disinflation, and its willingness to fight downward inflation pressures was credible.
Why is any of this relevant to the present? The Fed was already concerned that inflation was running too low. Not only is the inflation problem similar to the 2003 episode, the levels of core PCE are strikingly close around 1.6%. The “symmetric” inflation target of 2% asymmetrically missing to the downside. And the disinflationary coronavirus shock has yet to filter through the system.
In his most recent Press Conference, Chair Powell was thoroughly unconvincing when he said the FOMC continues to believe inflation will rise toward its target. A global growth shock is a headwind to further inflation, and the question how large the shock will be - not if there will be one.
With inflation falling, the Greenspan Fed realized real interest rates were rising. Simply not lowering interest rates further was akin to tightening. Greenspan himself was advocating for a 0.25% cut, but there was a fervent debate about 0.5% being the better size of the cut. Why? That sends a clear message about their commitment to their inflation goal. Eventually, Greenspan's 0.25% cut won the day.
Fast-forwarding to the present, there does not appear to be the same debate emerging at the Fed - yet. For the time being, disinflation pressure is not enough to concern them. But the coronavirus shock to global growth is not going to be miniscule, it is going to be sharp. The disinflation spillovers have not even begun to hit the system.
The primary difference between the FOMC then and now is the commitment to its inflation target. There may be a concern of losing credibility behind closed doors. But the commitment to its inflation target in 2020 is underwhelming. In June 2003, the Greenspan Fed was not debating whether to cut, it was debating how much to cut. The current FOMC’s attitude is “wait-and-see” about inflation. The Powell Fed needs an attitude adjustment.
The market expects a cut to come before the end of 2020. There is little chance the Fed can maintain its credibility or current policy stance in a falling inflation environment. Real rates will move higher, and the Fed will be forced to "accidentally" tighten policy or cut rates. The effects of the coronavirus will be transitory, but downward inflation pressures are a problem for the Fed's credibility. Greenspan’s Fed understood this well. Powell’s Fed is still learning.
The Fed will cut rates. The cuts of 2019 were to undo a policy error. The Fed must cut in 2020 to maintain a semblance of credibility.
Samuel E. Rines is the Chief Economist at Avalon Advisors in Houston, TX.