COVID-19 – The Fed Can't Cure What Ails You

The global spread of COVID-19 represents a classic example of a supply shock. In this case, the factor of production affected is labor. Despite the advance of artificial intelligence, global production of goods and services still depends critically on people. If fewer people are available to work, production of goods and services will decline. Monetary policy affects the aggregate demand for goods and services. If the aggregate output of goods and services declines because of an abrupt decline in person-hours of production, an increase in the demand for aggregate goods and services will result primarily in the rise in the aggregate price level of goods and services. That is, the pursuit of a more accommodative monetary policy in the face of a supply shock will result in stagflation. The degree of the stagflation depends on the severity of the supply shock and the degree of monetary policy accommodation.

We do not know how severe the COVID-19 global and US supply shock will be nor do we know its duration. Chinese production appears to have taken a hit as evidenced by the decline in the Chinese manufacturing purchasing managers to 35.7 in February versus 50.0 in January. The decline in Chinese manufacturing output will play havoc, at least temporarily, with global supply chains. I say “temporarily” because a new hospital was built from scratch in China in six days. I doubt if the Chinese rested on the seventh day. The point is that the Chinese are likely to be able to ramp up production quickly.

So far, the direct COVID-19 supply shock on U.S. production has been de minimis. It is not clear if there has been a net negative impact on U.S. aggregate demand. Although Americans may have cut back on travel and movie attendance, they have increased their demand for face masks and hand sanitizer. But if there were to be widespread shutdowns of K-8 schools in the U.S. in reaction to COVID-19, then there would be a significant negative supply shock to U.S. aggregate production of goods and services as parents presumably will need to stay home with their children rather than going to their place of work. (But don't worry about essential services being interrupted. We economists can churn out errant forecasts and faulty analysis from our isolation chambers so long as we have access to a high-speed Internet connection.) But, again, chumming aggregate demand via a more accommodative monetary policy won't increase the supply of goods.

Last week's swoon in the U.S. stock market was due to the realization that there is going to be a negative supply shock from COVID-19 that will adversely affect U.S. corporate profits. When your workers can't work as much or at all, your production will fall. If your production falls, your profits will fall. There is no uncertainty as to whether aggregate corporate profits will be adversely affected by COVID-19. The uncertainty is to the magnitude of the hit to aggregate corporate profits. Fed interest rate cuts, to the degree that they do not result in higher yields on longer-term maturity fixed-income securities, could cushion the downward pressure on equity prices by lowering the factor by which future profits are discounted. Fed interest rate cuts also could result in higher inflation in the face of the reduced supply of goods and services, as mentioned above. This would boost nominal corporate profits, but also would boost bond yields, the discounting factor of future nominal profits.

In sum, COVID-19 is going to have an adverse temporary effect on global aggregate output, including U.S. aggregate output, because of reduction in person-hours of work. There is nothing printing more money can do change this.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.