Lori Walsh: Now, we're going to talk about the economic impact of coronavirus in the US and in South Dakota. The Federal Reserve acted aggressively over the weekend slashing interest rates to near zero, an attempt to soothe the US economic turmoil.
Joe Santos is a professor of economics and Dykhouse Scholar of Money, Banking and Regulation in the Ness School of Management and Economics at South Dakota State University. You can find his blog online schooled.blog.com and he's joining us now on the phone. Joe Santos, welcome back. Thanks for being here.
Joe Santos: Hi Lori. Thank you.
Lori: All right. What the heck just happened? So, lots happened over the weekend. This is something that you and I were talking about, different tools in the macroeconomics tool shed, as it were. Let's start with the Federal Reserve and the action taken over the weekend. President Trump was getting up to do the press conference and was either handed the information right before the press conference and really focused on his satisfaction with that news. Tell people what happened, if they're just tuning in now, to that announcement, and then let's talk about what it means.
Joe Santos: Sure. So, this was very much a monetary policy action. Again, going back to your reference, the tools in the shed. This was the monetary policy tool. So, this was the Federal Open Market Committee of the Federal Reserve system meeting in an unscheduled way for the second time now. The first time was on March 3rd, that is, recently. Meeting to decide whether or not to change their federal funds rate target. And so, they met and they agreed to change the target. They lowered it. It's a range. Now, this federal funds rate target is between zero and 0.25%. So, this was a full one percentage point drop yesterday evening after an unscheduled Federal Open Market Committee meeting. So, this is quite unprecedented. The Fed acted in order to, as they like to say, unclog these short term credit markets. And we could talk a bit about that some more if you'd like.
But as far as the interest rate cut goes, it was a very drastic form of an otherwise conventional monetary policy that is using the federal funds rate. That's the rate that banks charge one another for reserves, think inventories, essentially. And so using that rate as an instrument of policy, again, except this time in a very dramatic fashion, lowering the range by a full one percentage point after an unscheduled meeting.
Lori: So, the president seemed enthusiastic, to me, about that. Almost, "It's about time. That's great news," and others. I was listening to a marketplace on NPR this morning, and there was also this sense that it can convey something that says, "Hey, we're really worried about this and can cause other concerns, too." What's the balance between acting decisively in an unprecedented fashion and then saying, "Yeah, we're..." I think the analogy they used was if you see a bunch of firetrucks going somewhere, part of you says, "Oh good, they're going to put out the fire." And part of you says, "Holy cow, that's a really big fire." So, talk about that a little bit.
Joe Santos: Yeah. Can I have that? That was really good.
Lori: It was on Marketplace. I didn't make it up. Yeah.
Joe Santos: That's right. So, when you see something so unprecedented, yeah, on the one hand you think they are really acting. And to your point, on the other, you think, "Gosh, how bad is bad?" I think the move was appropriate. That is to say lowering interest rates in dramatic fashion sooner rather than later. Later would have been waiting for just a few days, beginning tomorrow, when they would have their scheduled meeting. But acting in this way was a sort of monetary policy show of force.
It also had some technical features to it. This is a little bit deep in the weeds, but the credit markets were behaving very oddly in the last week. One feature that we were observing, it was quite concerning, was that there were certain relationships between various kinds of financial assets that were behaving in ways that we wouldn't expect. So, for example, when stock prices were going down, for a little bit so were bond prices. Typically what you see is stock prices go down and everybody rushes to the exit, and the exit is really US treasury bonds. And so this flight to safety usually causes a negative correlation between stock prices and bond prices. Well, last week both of those prices briefly went down. And that suggested that the markets did not have the necessary liquidity.
And so this is very technical, but that's really what the Federal Reserve, I think, is trying to do more than anything else is unclog these credit markets, which can be very, we say, segmented. Sort of little corners where you don't have the necessary liquidity and so you get these very odd behaviors in terms of the market prices and yields. So, they have been going in there to try to surgically address these corners of what we would call illiquidity. And I think that was exactly the thing to do.
This sort of plays out, as I said, as very conventional monetary policy where the Fed lowered rates on Sunday. I don't know that they were thinking so much that they wanted to lower rates for the conventional reasons of stimulating spending and so on and so forth. At least not at this moment while we're all sort of self quarantining, but more, again, to approach a very technical aspect of the markets, which was to unclog certain credit markets. So, what they announced was they will be buying now large quantities of treasury bonds, but also large quantities of other, so called, mortgage backed security. The idea is to get liquidity into these corners of the credit markets that seemed to have dried up, and certainly because of anxiety and other concerns. And as a result has led to a sort of a dysfunctionality in the credit market.
So, I think that very technical aspect is their primary concern. But in the process of doing that, when you pour that much liquidity into the market, you do also bring interest rates dramatically lower. And so that was, of course, the result as well.
Lori: Can you explain this idea of a negative interest rate? People who were throwing that around as other countries are doing this. What does that even mean?
Joe Santos: Yeah, so this gets to the second part of your analogy where you wonder, "Gosh, if those fire trucks are all racing in that direction, what does this all mean?" When you see what the Fed did, you realize very quickly that the lower range now, or the range now, is zero to 2.5% and it doesn't take much to look at zero and realize any lower than that is negative. And then to conclude that if the Federal Reserve policy, their position, is to not go negative, then they are at the lowest level they can possibly be. So, that's that moment where you realize, "Gosh, this is really extreme on their part because they've gone as low as they possibly can go." And this leads to your question. The reason we view it as low as they can go is because they have made the case that it is their position, and it remains their position as of the press conference yesterday evening, Chair Powell reiterated that they do not wish to induce negative interest rates.
A negative interest rate really makes your head hurt. It's a case where a lender is paying a borrower to take the money. This doesn't work as well as one would think in practice. And the reason, really, you can just go back to traditional banking where you borrow from Peter and you lend to Paul. Well, this is a case where you're lending to Paul at a negative interest rate, which means you also need to borrow from Peter at a negative interest rate. And Peter tends to not wish to do that.
And so intermediation, the process of borrowing someone's money and then lending it to someone else doesn't work very well in an environment of negative interest rates. In principle, on paper, you can borrow at negative interest rates and lend at negative interest rates, you can still make money. But in practice, it really clogs up intermediation. So, it turns out that there's mixed evidence on the effectiveness of this. In some ways, the basic intuition is, well, if zero is good, negatives got to be even better. But in practice, it doesn't play out quite that well. At least, this is the Fed's position on this. And so they have chosen to not go negative.
So, back to what they did yesterday, you might hear some argue they've done all they can now do. And again, in a conventional monetary policy sense, if they are not going to allow interest rates to be negative, that's true. They've done all they can do with their federal funds rate. But they can still do this more technical stuff I rattled off earlier. Go into various corners of credit markets, unclog them, and be very useful in doing that.
Lori: We also heard a lot about tax payroll, tax breaks and other things coming through Congress. I think we even heard that message from the Fed saying it's your turn to do your part, Congress, and the executive office of the president as well. What does that look like? What are we are already seeing happen in efforts to stop the economic panic and shore things up?
Joe Santos: Sure. So, we're seeing folks really come together on this notion that fiscal policy must now take the baton, if you will. They say there are no atheists in foxholes. So, your principles be darned. Now it's time to deal with a potential macroeconomic contraction. And so monetary policy has sort of done all it can in a conventional sense. Now it's time for fiscal. And by fiscal policy, as most folks probably know, this is government taxing and government spending. So, this is the purview, if you will, of the fisc or the treasury. And the thinking now is that what we need to do is essentially inject potential spending into the household.
As we know, the consumer is the largest percentage of gross domestic product spending. And so fiscal policy can do something monetary policy cannot. Monetary policy can lower the rates, but it's pushing on a string. The Fed can't make you borrow the money and spend it. Fiscal policy can inject spending capacity directly into the household. So, in the way of payroll tax cuts, some folks that said, just very sort of simply, send everybody $1,000. Now the way that plays out in practice is a little complicated, but in principle the idea is these folks have a propensity to consume if their income permits it. If you inject, if you will, those households with additional spending capacity, then they will sort of take that forward. And if nothing else, perhaps limit the reduction in economic activity that might otherwise occur when households try to, as we say, self-insure absent any sort of fiscal injection, self insure against the crisis. And in doing so, really sort of clam up and create all sorts of negative knock-on effect.
So, the idea is, yeah, inject spending capacity in the form of tax breaks, tax cuts, direct payments, what have you, to the households and that will then allow the households to spend going forward. The argument right now is, you can think of this from 50,000 feet, treasury yield are very low, which means, in effect, the world is actively seeking to lend its money to the treasury. And so this would be essentially the treasury borrowing those funds and then putting them back into the households in ways that the market might not otherwise do. So, that's the sort of principled argument for this kind of fiscal policy at this moment.
Lori: And that brings the question of tax cuts don't pay for themselves. This kind of fiscal policy, there's a bill to pay at some point, right?
Joe Santos: There is. And two quick things. One is there is going to be an effective policy, just a little bit of a tangent, to your point, it's got to be big. So, some of the numbers being thrown around, and of course no one knows for sure, but the idea right now is some of the consensus estimates are perhaps in the current quarter a 2% drop. This is annual. Not 2% for the quarter, but 2% on an annual basis of GDP. Perhaps, in the second quarter of 2020, a 3% drop annualized. So, if you're talking about numbers like 3% of GDP, if that's what we're going to lose as a result of a contraction, well, then very back of the envelope approximation, you'd want to inject, let's say 3% of GDP into the economy. That's about $600 billion. So, until folks are talking about B's not M's, billions not millions, and hundreds of billions, it's really not going to have the sort of force it would need to have in order to replace the kinds of economic losses that we're anticipating.
Having said that, this then comes to your question of, yes, but there's going to be a bill to pay. Well, as we always say, we always think about the debt of the US economy relative to GDP, the size of the US economy. So, in the case of the United States government, they do have a rather large outstanding debt. Quick numbers, think 20 trillion. GDP is about 20 trillion. So, it's about 100%, the ratio of debt to GDP. Certainly 80%, depending on how you measure it. So, if we take on more debt in order to inject this potential spending into households, we're going to increase outstanding debt. But if what we end up doing is succeeding in maintaining GDP growth and debt to GDP, the ratio that matters more than anything else needn't rise substantially.
So, imagine we take on debt or we do nothing and GDP falls. Debt to GDP actually goes up and we didn't even incur additional debt. Right? But GDP fell. So, by taking on additional debt, if we could stop the fall in GDP, or at least limit it, we could be in a better fiscal position than if we do nothing. So, it takes a moment to think about that that way. But again, ratios are what matter. So, the additional debt, no question. It's arithmetic. We're going to take on additional debt, but we may also end up preserving the growth in GDP, or at least limiting the loss and growth in GDP. The denominator, if you will, can be supported in ways that may leave us in, actually, potentially, a better fiscal position than if we sit back and do nothing.
Lori: So, you mentioned helping households rebound and do that consumer spending. How much is that complicated by the fact that households can't leave the household right now and so many of us really need to stay home? And that's not going to get better in a week.
Joe Santos: No. It's not going to get better in the week, but we're not going to get that money to the household in a week either. So, talking about it now, setting up the infrastructure now, determining how we can use the current infrastructure. It's actually not very easy to send every household $1,000, if that's what we decide to do. Technically speaking, that's much easier said than done.
So, there are various ways you can do this. Some folks have argued, for example, changing withholding tax tables in a very sort of blunt way so that there's an enormous payment to households sooner rather than later. But the point is we need to plan this now so that, hopefully, when this pandemic passes rather quickly, that is hopefully it's quick, it will pass, but hopefully it's quick, then, if you will, the potential spending is there and ready to go. So, even if households can't leave their houses, they've got the confidence to know that this is on the way. That can help. And then, ultimately, when they can leave their homes, they've got the financial wherewithal in order to act in a way that can limit the loss of economic activity. But your point's well taken. You're not going to do very much with it at the moment, but it certainly can't hurt. And then once you can act on it, the hope is that that would stimulate the economy. And some of these estimates, the very same folks, JP Morgan, Chase and other private estimates that say GDP could fall for a quarter to an annualized rate of 3%, also argued that then we can have a rather quick expansion out of this if we see something on the order of hundreds of billions of dollars of fiscal injections into the economy.
Lori: So, it's very similar to this idea of social distancing testing right now to avoid overwhelming the healthcare system. We prepare now, and then we'll be ready to mitigate this whole thing in the future, hopefully.
Joe Santos: Yeah, that's right, because as this economic activity is lost, there are economists called dead weight loss. There's something, a transaction, you and I were about to engage in, it would have been mutually beneficial and it doesn't happen. If enough of that dead weight loss is incurred, that will really deteriorate the economy. Jobs will be lost, and there simply will be effects that will be very difficult to repair. The sooner you can act, and really not let any of that actually happen, the better. So, that's the argument for speed, as you said, and it's in many ways analogous to the argument for speed in the epidemiological context.
Lori: All right. Joe Santos, professor of economics and Dykhouse Scholar of Money, Banking and Regulation in the Ness School of Management and Economics at SDSU, currently isolated and on the phone with us today instead of in our studio at South Dakota State. Thanks Joe. Really appreciate your time.
Joe Santos: Thank you, Lori.