The Federal Reserve slashed the federal funds rate in response to the effects of the COVID-19 pandemic. The full impact of the pandemic on the economy is still uncertain and depends on many factors. Analysis suggests that allowing the federal funds rate to fall fast will help the economy cope with the aftermath of COVID-19. In particular, the limited policy space due to the effective lower bound of the federal funds rate before the pandemic reinforces rather than offsets the need for a rapid funds rate decline.
To simulate the effects of the pandemic I consider scenarios with two simultaneous negative effects in the economy. First, labor productivity falls, which means businesses produce fewer goods and services for each hour of labor. This loss in efficiency reflects such things as less effective work-from-home arrangements, technology hiccups from overtaxed telecommuting tools, and home childcare responsibilities. Second, the public’s willingness to spend also falls due to policies that mandate avoiding nonessential travel and closing nonessential businesses, which lowers overall demand for goods and services in the economy.
I assume that low productivity and weak demand start in the first quarter of 2020 and worsen in the second quarter. Afterwards these effects taper off such that they subside to half their peak strength in three quarters, by the end of the first quarter of 2021. I then assume that the Federal Reserve chooses the federal funds rate level to keep inflation and unemployment as close as possible to their objectives without relying on promises of future actions.
It is extremely difficult to determine the size of the productivity and demand decreases. In my baseline scenario, I assume that they are twice the size of the average fluctuations over the past 30 years. Such large simultaneous drops are extremely unlikely in normal times, but the pandemic’s effect is already well beyond normal relative to the past 30 years. This scenario thus provides a way to evaluate the offsetting effects of alternative policy responses.
Figure 1 shows the simulated paths of unemployment and four-quarter core PCE price inflation in response to the baseline scenario for the two policy alternatives. With the aggressive policy (blue lines), unemployment reaches 6.8% in the last quarter of 2020, and inflation falls to as low as 1%. If policy is slower to adjust (green lines), then unemployment reaches 10.4% in the first quarter of 2021 and inflation falls as low as –1.4%, which are much worse outcomes. This shows that the failure to anticipate dire conditions can be compounded by limited policy space to yield substantially worse outcomes.
Figure 2 shows the economic outcomes for two alternative scenarios relative to the baseline (blue lines). One alternative is a severe contraction (red lines), in which productivity and demand fall by three times the normal fluctuations over the past 30 years. The initial drop in productivity and demand is only 50% more substantial than in the baseline scenario, but the lack of policy space due to the effective lower bound implies that the increases in unemployment and decreases in inflation are more than proportional to the severity of the scenario. In this case, unemployment reaches 9.6%, even with an aggressive policy response, and inflation falls as low as 0.4%.
Chosen excerpts by Job Market Monitor. Read the whole story @ Federal Reserve Bank of San Francisco | Mitigating COVID-19 Effects with Conventional Monetary Policy