Is the Fed Insensitive to Coronavirus Risks -- Mistakes By Fed Officials

The coronavirus appears to be beginning to impact US and global economic activity, at least according to Markit surveys.  Fed officials' comments are not helping the matter for the markets.  For the stock market to recover from the latest sell-off, there has to be good news regarding the virus.  Or, the Fed needs to step in with more contingency-supportive messages.

The coronavirus' impact on business activity is showing up in Markit PMI surveys for February.  European and US manufacturers cited virus-related production disruptions in China as a factor hurting business activity.  The negative influence can surface again in some US data over the next couple of weeks -- Chicago PM, Durable Goods Orders (although there is some positive evidence here, as well), Mfg ISM, and Employment Report.  At this point, the Claims data suggest a smaller m/m job gain than January's +225k.

Fed officials are making mistakes and thereby exacerbating the market impact of coronavirus fears.  In a CNBC interview, Fed Vice Chair Clarida disagreed with the Treasury market's having built in expectations of rate cuts this year.  St Louis Fed President Bullard dismissed these expectations as just a temporary reaction to the virus fears.  These officials emphasized the FOMC decision to keep rates steady, while not tempering it with a promise to act if needed.  More appropriate comments from officials would stress that the Fed is ready to react to significant economic fall-out from the virus.  They also could say the latter is not the case so far.  Both ideas would stem market fears.   Comments along these lines should be watched for in the coming week or so.

By emphasizing the FOMC decision for a steady policy, officials could be repeating the mistake made by Fed Chair Powell in October 2018.  Then, his comments focused on the FOMC decision to hike rates through 2019.  They failed to adequately acknowledge the downside economic risks from the US/China trade dispute.  His comments and mistaken December rate hike contributed to the stock market plunge in Q418.  Both then and now, Fed officials stuck to a rate policy that was not sensitive enough, if not blind, to downside economic risks.

By doing so now, the latest Fedspeak is essentially equivalent to a tightening -- it downplays the probability of an easing ahead.  It runs counter to my prior blog's argument that a steepening of the Treasury yield curve would provide the best signal that a Fed tightening is needed.  By implying the recent decline in Treasury yields is wrong or overdone, as did Clarida and Bullard, officials are claiming to have a better knowledge and understanding of future risks than does the market.   This assumption is particularly dubious given that the extent to which the virus will spread is highly uncertain.

Indeed, having Fed officials promise a "safety net" if needed is particularly important now.  According to an expert cited by Holman Jenkins Jr in a Wall Street Journal op ed piece,  the "next three weeks are going to be critical" with regard to the spread of the virus.  If a global pandemic can be avoided by good policy, the virus' spread should abate as the weather turns warmer and more humid.  But, there is no certainty a global pandemic can be avoided.

The irony of taking an inflexible stance to policy is that the market reactions will be opposite to what officials desire.  In the face of downside risk and little chance of Fed response, Treasury yields will take on more of the burden to address a potential negative impact of the virus on economic activity and fall further -- in contrast to  Clarida's complaint that they were incorrectly building in rate cuts.  The markets take over the task of cushioning the economy.   Treasury yields take on even more of the burden if the stock market declines and dollar strengthens in response to the downside risk.

From a political perspective, the Fed opens itself to the anger of both the Administration and Congress if it does not take an aggressive stance -- at least in its communications -- toward the potential economic harm from the coronavirus risks.  It also could lose the respect of the public.  Fed independence and/or new leadership eventually could be at stake.