To set the scene from earlier this week: US equity markets are in freefall, President Trump is tweeting furiously at Jerome Powell, and concerns of an uncontrollable COVID-19 pandemic are growing. Then, completely out-of-the-blue, the US Federal Reserve announces an off-schedule interest rate cut of 50 basis points. And thus the markets were appeased; a central bank had come to the rescue, as has become the established pattern since the financial collapse of 2009. Yet, in a troubling sign for policymakers, the resulting reprieve from market volatility was exceedingly brief. This suggests that either the unconventional monetary policy toolbox is running out of tools or that COVID-19 represents a far more serious threat than any cyclical downturn.

In truth it could be both.

Analysis

We live in a time of ultra-loose monetary policy, when cyclical and demand-side certainties of the past have been eclipsed by unconventional sleights like quantitative easing and negative interest rates. These new policies began in earnest in the wake of the 2008-2009 financial crisis, when central banks coordinated action to inject liquidity and restore trust in a financial system that had almost entirely seized up. And though they were successful in averting catastrophe in 2009, they have continued to be employed again and again by policymakers seeking to head off any and all hint of economic pain. Exhibit A: negative interest rates in Europe and Japan, which are intended to preclude a deflationary spiral. Exhibit B: Australia’s intention to join the ‘QE club.’ Exhibit C: the Federal Reserve’s resumption of US Treasury purchases toward the end of last year. Broadly speaking, these policies have produced plentiful cheap money (read: debt) and sky-high asset prices, whether real estate or equities.

Now we enter the unknown of COVID-19 – a true ‘black swan’ event that risks producing a deep and protracted dip in aggregate demand. How will monetary policy fare as a tool to contain the economic fallout?

The early indications are not positive.

First of all, it’s worth noting that unconventional monetary policy might have already been encountering diminishing returns well before the COVID-19 outbreak emerged. The warnings were plentiful, and they came from some highly authoritative sources. In 2019, Ben Bernanke noted that a declining real interest rate (the interest rate that would prevail without central bank intervention) meant central banks would not have a lot to work with in the event of a major recession. The notion was seconded by Janet Yellen, who in a 2018 interview warned that “it wouldn’t take a very serious recession at all” for US interest rates to hit the zero mark. In its 2019 economic outlook, the OECD indicated that fiscal tools would increasingly be needed to complement the monetary-based approaches of the past decade in order to keep the global economy humming. Finally, the Bank for International Settlements – the ‘central bank for central bankers’ that is generally favorable toward unconventional monetary policy – released a report late last year highlighting various market distortions that have been created by the QE era, including illiquidity in certain markets and bloated central bank balance sheets. The report cited one incident in particular – last September when the overnight repo rate suddenly spiked by 10%, prompting the Fed to inject $140 billion of cash into the market – as evidence of potentially destabilizing side-effects of a decade of QE.