This week the corona virus has hit global financial markets hard and it is now clear to everyone that this is a significant and hard negative shock to the global economy and a shock that likely requires a response from central banks around the world. The question is how to react. I will try to answer this in this blog post.

Overall, one can start out by noting that central banks have the responsibility of broadly speaking ensuring nominal stability.

I would generally prefer this to be some kind of nominal GDP (level) target for most central banks, but for most central banks nominal stability is interpreted to be some kind of inflation target – in the case of the ECB and the Federal Reserve 2% inflation.

So here I will take the inflation target as given and I will also take it as given that the normal modus operandi for central banks like the ECB and the Fed is some kind of interest rates targeting – the central bank controls the money base in such a fashion to hit an short-term money market interest rate to in turn ensuring hitting the inflation target in the ‘medium-term’.

Supply shock or demand shock?

The central question when assessing how to react to the ‘corona shock’ is answer whether the shock is a (nominal) demand shock or a (real) supply shock. This is important as the (correct) textbook answer is that central banks has 100% control over nominal demand in the economy (remember M*V=P*Y=NGDP) so if the shock in any way lowers nominal demand the task of the central banks is to offset this shock to ensure nominal demand (nominal GDP) stays on track and does not cause inflation expectations to decline below the central bank’s inflation target.

On the other hand, central banks cannot – at least not for the longer run – control the real side (the supply side) of the economy (the Phillips curve is vertical in the long run) and hence the textbook tells us that central banks should not react to supply shocks. But what does “not react” really mean? Let’s answer that question first.

Don’t turn a supply shock into a demand shock

It is pretty clear that the imitate effect of the ‘corona shock’ has been to shot down production in the affected areas in China and as China is a subcontractor to the global manufacturing industry this in turn becomes a supply shock not only to the Chinese economy, but also to the global economy.

In a AS-AD framework a negative supply shock shifts the AS curve to the left causing production (Y) to drop and push up prices (and as long as the supply unfolds also inflation).

If the central bank is focused very much on present headline inflation such a shock might cause the central bank to tighten monetary policy by for example hiking its key policy rate. This is the mistake the ECB did in 2011 when rising oil prices caused headline inflation to increase in the euro zone.

Alternatively, the central bank can observe the drop in economic activity (lower Y) and conclude it needs to offset this by increasing aggregate demand and hence need to ease monetary conditions. This is essentially what central banks did in the 1970s when they reacted to lower structural growth rates and numerous oil prices shocks. These shocks clearly were negative supply shocks which didn’t warrant an easing of a monetary response.

Hence, the textbook on this is clear – central banks shouldn’t try to shift the AD curve when the AS curve moves. Rather the central bank should singlehandedly focus on keeping nominal demand (the AD curve/NGDP growth) on track.

This leads us to the conclusion that as long as the ‘corona shock’ is a negative supply then central banks shouldn’t (as they really can’t) try to do anything about it.

However, that is much less straight forward than it sounds because what does “doing nothing” really mean?

Take for example the People’s Bank of China (PBoC). The PBoC really doesn’t have a clear monetary policy target, but it is clear that it at least to some extent both is trying to keep inflation anchored but also has some time clearly have preferences regarding the level and fluctuations of the Chinese currency the renminbi (CNY).

So, for the sake of the argument lets assume that PBoC is targeting a level for CNY against either the dollar or a basket of currencies.

Now imagine the ‘corona shock’ hits. As this is a negative supply shock it is essentially also a negative terms-of-trade shock, which would cause a freely floating CNY to weaken (rather significantly).

If we look at the CNY it is notable just how stable it has been since we got the first reports regarding the corona virus.

This is particularly remarkable given the fact that all indications are that economic activity in China has plummeted. Had the CNY been freely floating we surely should have seen the CNY weakening a lot. That hasn’t happened. There can only be on reason for that – the PBoC is effectively intervening to stop the CNY from falling sharply.

However, if we look at the commentary regarding the PBoC’s actions we get the impression that the PBoC has been injecting cash into the financial markets in a response to the crisis. That of course to some extent is correct, but it is only part of the story as it is not everything we see.

I am for example pretty sure that the PBoC actively is telling banks and major investors in China not to sell the CNY (or hedge it) and further more China is also operating currency controls, which keeps the sell-off of the CNY in check.

A place where we see this monetary tightening is in M1 growth. Hence, in January M1 dropped sharply compared to December, which in my view is a clear indication of the effective tightening of monetary conditions in China.

Said in another way, the PBoC by not allowing the CNY to drop (enough) is by default engineering a rather unwarranted tightening of Chinese monetary conditions. Consequently, the PBoC is turning a negative supply shock into a negative demand shock.

Interest rate targeting is causing monetary tightening in the US and the euro zone

And the same is the case in the euro zone and the US, but here the mechanism is not exchange rate targeting, but rather interest rate targeting. Hence, both the Fed and the ECB are primarily conducting monetary policy by trying to control the short-term money market rates. Effectively, what the Fed and the ECB is trying to ‘shadow’ the natural interest rate to keep monetary conditions neutral.

The natural interest rate is not constant. It moves for all kind of reasons – for example risk appetite, demographics and structural growth trends.

This also means that the natural interest rate should be expected to be moving in response to supply shocks. Hence, we should expect the real natural interest to move down when the economy is hit by a negative supply shock.

Consequently, an interest rate-targeting bank should cut rates to reflect the drop in the real natural interest rate triggered by a negative supply shock.

This is NOT an easing of monetary conditions. It just ensures that monetary conditions are keep unchanged.

This is an extremely important point. If the central bank does not want to do “anything” then it needs to cut interest rates in response to a negative supply shock.

This can seem paradoxical but is a logic consequence of the kind of interest rate targeting regime both the ECB and the Fed operate.

That being said, the question still is how large this negative supply shock really is on the US and European economies and whether it has caused the real natural interest rate to drop.

A way to look at this is to look at the market pricing.

Hence, if we for example look at the nominal 5-year US Treasury bond yield minus 5-year market inflation expectations then we see that real yields – a proxy for the real natural interest rate – has drop significantly since the beginning of the year.

This to me is a rather clear indication that the Federal Reserve needs to cut its key policy rate significantly soon, but it is important to note that this essentially is a policy of ‘doing nothing’ as it just will align the real policy rate with the actual drop in the (short-term) real natural rate we have seen. And the same goes for the ECB.

This also means that by not changing their policy rates in response to lower real natural rates the ECB and the Fed effectively at the moment are tightening monetary conditions – effectively pushing the AD curve to the left (pushing down NGDP growth).

This is very visible when we look at market inflation expectations – they have dropped significantly in recent weeks in response to the unfolding of the ‘corona shock’ and the hesitant communication from central banks around the world.

Said in another way because the ECB and the Fed are hesitant in their communication regarding the ‘corona crisis’ they have caused an unwarranted tightening of monetary conditions, which greatly is exacerbating the global economic consequences of the ‘corona shock’.

Foot-dragging central banks might turn this into a global recession

Central banks never act fast and there are often good reasons for this and I am certainly not arguing that central banks should be sitting and micromanage the global economy with a joystick, but the problem is that when central banks insist on either targeting the exchange rate or interest rates then negative supply shocks turns into negative demand shocks if central banks either don’t allow exchange rates or interest rates to drop sufficiently to reflect the negative supply shock.

Ideally, I would like central banks to control monetary conditions by setting permanent growth targets for the money base (relative to money demand) to hit a NGDP level target, but we do not live in my ideal world.

We live in a world of very imperfect inflation targeting and interest rate controls. In that world central banks need to keep a close eye market inflation expectations and market real rates.

Right now, the market is telling us that a major global negative supply shock has hit us and that that should cause the CNY to weakening sharply and real policy rates should drop in significantly in the euro zone and the US.

However, due to the conservativism of the PBoC, the ECB and the Fed (and most other central banks for that matter) we are likely to see this crisis becoming a fairly large negative demand shock and we know that negative demand shocks (lower NGDP) always causes financial distress (that is why for example VIX is sharply up this week).

I do think central banks eventually will react to this, but they will be foot-dragging and therefore this will get worse before it gets better.

Therefore, we are in my view likely to see more financial distress, but I also think that that will trigger central banks around the world to act – sooner or later – and I think that we within weeks very well could see coordinated global actions from central banks to ease monetary conditions (they will call it ‘inject emergency funds in the financial system’ or something like that).

But this would not be necessary if central banks just did their job and ensured market inflation expectations are kept close to their inflation targets. They are not doing that right now.

Christine Largard and Jerome Powell could send out a join statement today that both the ECB and the Fed are targeting 2% inflation and that both central banks will increase their money bases enough to ensure that for example 5y5y market inflation expectations hit 2%. That would end the negative demand shock part of the ‘corona shock’ immediately and likely would ensure that does not turn into a global recession.