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The US Federal Reserve (Fed) cut rates today by 0.5%, taking the Fed Funds target range down to 1.0% to 1.25%. In its press statement the Fed noted that, while the US economy remained “strong”, the coronavirus poses evolving risks to the outlook. Importantly, the text clearly leaves the door open for further action, with the Fed to “act as appropriate” to support the economy.
The speed and size of the move tells us something about the Fed’s reaction function. We had flagged that an emergency cut was possible this week. However, we thought that this would require additional increases in financial stress and/or further bad news on the coronavirus.
Instead, the Fed has chosen to take action proactively in the wake of last week’s market rout, and given that the extent and impact of the outbreak in the US still highly uncertain. This underlines the sensitivity to financial shocks that the Fed has displayed over recent years. It also suggests that they are minded to react aggressively to downside risks, especially with inflation still tepid.
A more critical take would suggest there is a hint of panic in this move, with Fed speakers having sounded relatively blasé on the risks from coronavirus just a week ago. Indeed, the market rallied moderately on news of the cut, but fell back during Powell’s press conference.
This highly responsive reaction function would seem to suggest the Fed is not done yet. With the market having already moved to price in a significant easing in interest rates, today’s move alone may be insufficient to bring financial stress lower. Moreover, new infections in the US and abroad are likely to rise over coming weeks and economic disruptions will become increasingly apparent in the data flow.
While all these factors are highly fluid, it now looks likely that the Fed will cut rates by another 0.5%, either in one fell swoop in March, or split between 0.25% steps in March and April. Further cuts all the way to the lower bound (0-0.25%) are to be expected if financial stress continues to rise and the shock from the virus proves even more disruptive. In this case, a recommencement of asset purchases is likely to be the Fed’s next option.
In total, this would represent 1.75% of easing by the Fed over the past 12 months, first in response to the US-China trade war and now to insure against coronavirus risks. Through this period, the unemployment rate has remained stable at 50-year lows. While it is certainly true that conditions would likely have been weaker without this action, it does come at an implicit cost of diminished policy space and less scope to react to negative shocks in the future.
Diminishing monetary policy firepower puts the onus on fiscal policy to respond, both to this and future shocks.
Diminishing monetary policy firepower puts the onus on fiscal policy to respond, both to this and future shocks. President Trump asked Congress for a $2.5 billion package to fight the coronavirus, with half of this firepower coming from a redistribution of funds from other accounts. Congress looks set to pass an emergency funding package in the near future of around three times this size, with more of this unfunded as the emergency builds. In headline terms, this is still a marginal change in the overall fiscal position, with the 2019 deficit estimated at $984 billion. Therefore, we do not expect this to generate meaningful macroeconomic impacts. The scale of response could increase, but we will first need to see a much more severe rise in US infections.
Interest rates are a blunt tool for fighting this type of shock in the short term. Certainly, they can do little to alleviate supply-chain disruptions, travel restrictions and more cautious near-term spending/investment in response to uncertainty. Therefore, it seems unlikely that lower rates will avert the immediate growth shock that we believe is taking hold.
However, they may be more effective at preventing this shock from becoming entrenched. First, rate cuts are likely to mitigate further increases in financial stress, which in itself can pose risks to the economic cycle through a range of channels. Second, lower interest rates can provide some support to leveraged businesses and households, some of which might face disruptions from the coronavirus shock. This might prevent liquidity issues from becoming solvency shocks. Finally, the move should support sentiment to some extent, signalling that the central bank is ready to act forcefully.
The path for coronavirus infections and the impact on the real economy remain hard to forecast. Our global forecasts compiled just a few weeks ago have rapidly moved from the more pessimistic side of consensus to the more optimistic. We are updating these, along with some scenario work, which might tell us how things could look outside of our new base case, and what would take us there.
Without prejudging this work, it is likely that our global growth forecasts for 2020 will fall closer to 2%, with growth in year-on-year terms troughing in the second quarter. However, this lost output will still largely be made up, albeit a little later in our baseline. Finally, the risks to both demand and supply are probably more heavily tilted to the downside.
Today’s aggressive and proactive action might suggest we should be a little more confident that, even if we see a deeper, more widespread and protracted shock, this will be followed by a rebound - especially if we are right that lower interest rates might help economies avoid some of the second-round effects of the downswing. However, there will naturally come a point at which the disruption is too severe to offset with looser policy.