Fed's emergency 50 basis point rate cut: cautious, but was it wise?

The Fed held an emergency conference call meeting and cut its Federal funds rate target today by 50bp to 1%-1.25%, two weeks before its scheduled March 17-18 FOMC meeting. There were no dissents. The fears and unknowns about the coronavirus and its economic impacts have put the Fed in a very difficult situation. It acted decisively, taking what it perceives to be a cautionary step. Whether it proves to be effective or wise is yet to be determined.

The Fed’s emergency easing followed an announcement from the G7 Finance Ministers and Central Bank Governors were closely monitoring conditions.

The Fed perceives the virus poses downside risks to the economy (Fed Chair Powell: “the Committee judged that the risks to the U.S. outlook have changed materially.”) The decline in inflationary expectations and expected decline in headline inflation further below the Fed’s 2% target provides the Fed the perceived flexibility to ease while remaining consistent with its dual mandate. While there is scant hard data indicating economic harm, Powell stated that they “are seeing effects on tourism and travel industries and hearing concerns from industries that rely on global supply chains.”

Importantly, the virus effectively is a real negative shock to global aggregate demand and supply, and cannot be fixed through normal monetary policy easing channels (China’s economy: after the fall, what kind of recovery?, February 19, 2020). This is particularly true insofar as monetary policy and financial conditions are already easy, with more-than-ample bank reserves and the lowest bond yields in history. Easing will not stimulate consumption and investment.

The Fed understands this. It also knows that while the coronavirus is unique and scary, it will be a temporary phenomenon, and eventually the economy will get back to its potential growth path. Of course, nobody knows how long “temporary” is. Rather, the Fed cut rates to lift confidence—in both financial markets and the broader public—and particularly ease the intense risk aversion that had gripped financial markets in recent days and in doing so, to dampen volatility.

It is uncertain whether this emergency, inter-meeting rate cut will effectively serve the purpose of lifting confidence. It may be successful; on the other hand, it may not, particularly if there is any further negative real news on the spreading of the coronavirus and associated disruptions. Initial market responses to the Fed’s cuts have not been positive. Let’s be realistic: fears and uncertainties about the coronavirus will lift when there is convincing positive real news that its spread is ebbing. The Fed’s monetary easing does not change that reality.

Chair Powell was asked in his press conference if the Fed would raise rates if the damage to the economy turns out to be less severe than expected. His response was that “if we get to a place where it is an appropriate time to change the [monetary policy] stance, we won’t hesitate to do that.” We give credit to the Fed for its transparency, but remain concerned that the Fed has a very unhealthy relationship with financial markets (The Fed and Financial Markets: Suggestions to Improve an Unhealthy Relationship, May 2, 2019), and worry that this emergency cut may reinforce that (markets always crave monetary easing, and the Fed accommodates) and also worry that when the virus fears pass, the Fed will not take away the cuts.

At the Fed’s strategy conference in June 2019, when the Fed funds rate was 2.25%-2.5%, Powell stated that the largest challenge facing the Fed is the effective (zero) lower bound, indicating at the time that negative policy rates were not an attractive option. The Fed immediately commenced with three 25 basis point “insurance rate cuts” in response to trade policy and international uncertainties, lowering the policy rate to 1.5%-1.75%. This clearly indicated that the Fed was willing to ease policy even though there were no signs of recession. When it was clear that the uncertainties had dissipated and the economy continued to grow along the Fed’s earlier projected path, the Fed did not take away the insurance cuts”, leaving the Fed closer to the zero lower bound.

With this emergency ease, the Fed is closer yet to the zero bound (Chart 1). We sincerely hope the coronavirus dissipates and its economic impacts are small, providing the Fed flexibility to reverse this cut.

Additional observation: the real negative shock to aggregate demand and supply stemming from the coronavirus differs fundamentally from both the financial crisis of 2008-2009 and the oil price shocks of 1973 and 1979. As such, the appropriate policy responses for one crisis is not appropriate for another. A coordinated and credible response from Washington policymakers is required.

The deep recession of 2008-2009 started with a financial crisis—a temporary virtual ceasing of the normal functioning of U.S. and global markets that generated panic and uncertainties that led to extreme risk aversion—that led to a temporary sharp decline in consumption, business activity and investment spending and trade. As a financial crisis, aggressive monetary intervention and unprecedented easing was appropriate and necessary. The Fed deserves credit for helping to end the financial crisis and ending the deep economic contraction. We note that coordinated easing among leading global central banks was critical to stabilization of financial markets and economies.

The oil shock of 1973 involved a dramatic near 400% spike in oil prices and severe constraints on oil, gas and energy supplies stemming from the Arab oil embargo that was aggravated by misguided economic policies (including rationing) that threw the U.S. economy into deep recession that lasted for six quarters. Policymakers have learned from those policy mistakes.

Chart 1: Fed funds target rate

Sources: Federal Reserve Board and Berenberg Capital Markets

Mickey Levy, mickey.levy@berenberg-us.com

Roiana Reid, roiana.reid@berenberg-us.com

Member FINRA & SIPC
This email and any files or attachments transmitted with it may contain confidential or privileged information and are intended solely for the use of the intended recipient. If you are not the intended recipient, please do not copy, retain, disclose or use any part of the message or its attachments. Please notify the sender immediately by return email and destroy or delete any copies. Dissemination or use of this information by anyone other than the intended recipient is unauthorized and may be illegal. Communications by email cannot be guaranteed to be secure or error-free. Emails and their attachments are subject to being intercepted, becoming corrupted, getting lost or delayed, or may contain viruses. Therefore, neither the sender nor Berenberg Capital Markets LLC (BCM) accepts any liability for any errors or omissions in the content of this message or problems in its transmission, including those arising as a result of its transmission over the internet.
BCM does not assume liability for the correctness and completeness of all information given and/or attachments contained herein. The provided information has not been checked by a third party, especially an independent auditing firm. BCM explicitly points to the stated date of preparation. The information given can become incorrect due to passage of time and/or as a result of legal, political, economic or other changes. BCM does not assume responsibility to indicate such changes and/or to publish an updated document. Any document(s) or attachment(s) is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers.
In light of upcoming regulatory changes, please be informed that BCM will continue to share information with you until unsubscribe@berenberg-us.com receives your termination/deletion request. For more information about the General Data Protection Regulation (GDPR) and our privacy policies please refer to https://www.berenberg-us.com/legal-notice. BCM reserves all the rights in this communication. No part of this communication or its content may be rewritten, copied, photocopied or duplicated in any form by any means or redistributed without BCM’s prior written consent.
The information contained herein and sourced may have been adopted from various news sources, for example, Bloomberg, Reuters, Street Account and various other sources. BCM does not claim accuracy, completeness, timeliness, suitability, or otherwise regarding all the information on the securities, stock markets, or developments referred to within. On no account should the Content be regarded as a substitute for the recipient procuring information for himself/herself or exercising his/her own judgments. BCM is not responsible for any recipient(s) use of this information. This Content is not a solicitation or an offer to buy or sell any of the securities contained herein. This information does not constitute a recommendation or take into account the particular investment objectives, financial situations, or needs of clients. Clients should consider whether any advice or recommendation in this Content is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of securities which may be referred to in this Content and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain securities.