Even as global forecasters were still debating the economic impact of Covid-19’s spread beyond China, the US Federal Reserve pulled out the big guns on Tuesday to lower its policy rate by 50 basis points, in what it called an ‘emergency’ rate reduction. Though the Fed described this as a pre-emptive measure to head off evolving risks to the economy from the outbreak, the financial markets weren’t convinced, with the Dow Jones Industrial Average falling by nearly 800 points and the 10-year US treasury yield dipping below 1 per cent after the cut. Perversely, for a measure that was meant to bolster confidence, the markets seemed to interpret it as a sign that the impact of this outbreak on the US economy would be far worse than the current infection and fatality rates suggested. As the RBI joins the global chorus of central bankers in promising ‘appropriate action’ to deal with the domestic coronavirus outbreak, it would do well to keep this US market reaction in mind.
Having pledged the use of ‘all appropriate policy tools’ to tackle the virus menace, other members of the G7 now seem to be caught between a rock and a hard place in following the US example. The ECB’s deposit rate is already at an unprecedented minus 0.5 per cent and the Bank of Japan’s policy rate at minus 0.1 per cent. While rate cuts and quantitative easing may have helped the US economy chart a recovery from the global financial crisis, these methods have failed in lifting the Eurozone or Japan out of their low growth spirals. Instead, these economies are now grappling with the debilitating downsides of negative rates — shrinking savings, capital flight, thinning bank margins and the threat of bank failure — which can wreak as much damage on economies as any virus outbreak.
The dilemma for India’s central bank is not as dire, given that its policy rates are on a pause and are still at 5.15 per cent. But rate cuts in upcoming meetings may entail a tight-rope walk for the Monetary Policy Committee for two reasons. One, with the CPI print stubbornly high at over 7.5 per cent and food inflation in the double digits, inflation rates are already well over the MPC’s 4-6 per cent comfort zone. Global commodity declines sparked by the coronavirus scare may temper inflation in fuel and industrial inputs, but perhaps not in food prices. Two, global risk-off situations usually spark a run on the rupee and the MPC will have to weigh the impact of rate cuts on capital flows too. Given that the key risk that the coronavirus poses to the economy is a potential supply-side shock from disruptions to output, it is also a moot point if conventional monetary tools can really counter its effects. Timely real economy and trade policy measures that tackle supply-side issues may be more effective at ring-fencing India from the virus impact.