Fed: A Material Reassessment

Published on March 3, 2020

While we were frankly stunned by the Federal Open Market Committee’s consensus decision to cut the policy rate by 50 basis points this morning to a 1%-1.25% fed funds target range, a few quick points looking ahead:

*** First, barring some sort of credit market dislocation that doesn’t seem to be the case, our sense is that the FOMC concluded they could not wait until the March meeting for a rate move as they had intended and that, instead, the central bank may need to begin front-loading as much accommodation as possible as quickly as possible as the path of least regret in case the outlook indeed worsens. ***

*** This would literally then be the first down payment on the “swift and aggressive” rate cuts mapped out under the much discussed Reifschneider-Williams playbook when in such close proximity to the Zero Lower Bound. Indeed, while the actual rate path will obviously depend on how the data plays out and forecast is reassessed, the new policy orthodoxy when facing very low inflation and short run r* is to punch rates down quickly as soon as a recession risk crosses into high probabilities. ***

*** We now think another 50 basis point rate cut is the higher probability at the March 17-18 FOMC meeting over a less aggressive 25 bp easing, while no further moves to wait for hard data feels is a significantly lower probability. What’s more, our sense is that if the outlook does indeed darken in the coming months, a probability that is now hard to dismiss, there is likely to be a firm Committee consensus to continue cutting to bring the policy rate back to the Zero Lower Bound as early as the first half of this year. ***

“Swift and Aggressive”

As Chairman Powell affirmed in the presser, the anecdotal evidence gathered through the District network of contacts is already suggesting the coronavirus effects were grim enough to warrant a “material” reassessment” of the forecast without waiting for the actual data. On that front, it is noteworthy that the FOMC opted to retain the “act as appropriate” language in today’s statement that Powell used on Friday, and which had framed the three rate cuts last year.

In the absence of the “material reassessment” that Chairman Powell cited in his remarks to the press, the FOMC was determined to stick to a lagged reaction function through this year (SGH 2/26/20, “Fed: The Near-term Reaction Function”); and in a perfect world, they had hoped to focus on the reset to the policy framework that has been telegraphed for the June FOMC meeting.

But with further coronavirus cases and deaths likely in the coming weeks, along with more schools closing, curtailed travel, disrupted supply chains and lower consumer spending, we suspect the March Summary of Economic Projections are likely to see sharply lower growth, if not recession.

And it is in those elevated probabilities of a recession or near recession that the Reifschneider-Williams paper calling for “swift and aggressive” rate cuts comes into the policy calculation (SGH 9/16/19, “Fed: The September Meeting”). We would note that there is a broad consensus across the Committee on the need to maximize the impact of what little rate space there is when in the current proximity to the Zero Lower Bound.

The hope is that the maximum accommodation possible when so near the Zero Lower Bound will help soften the downturn, ease balance sheet pressures, and perhaps lead to a shallower trajectory for the economy in “coming out the other side” from hit to growth.

So while the economy “remains in good shape,” at least officially, and for now, our sense is that it is this revamped approach, assuming the recession risk is rising, that is driving the dramatic downshift in Fed’s still evolving reaction function and the current consensus for such a dramatic inter-meeting rate cut, and not merely, as more widely assumed, an effort, unsuccessful to boot, to throw a circuit breaker in sentiment through a short live pop in asset prices.

An Accelerated and Expanded Policy Review

We would dismiss the chatter that the Fed acted prematurely under the political pressure from the White House – although President Trump’s renewed tweets and criticisms are not making it any easier for the Fed – and we equally dismiss out of hand the notion the Fed’s rate cut decision was driven merely by stock market concerns.

Short of a free fall so rapid it threatens systemic concerns, most Fed officials are appreciative, if that is the right word, that the markets seem to be functioning in their price discovery role.

For what it is worth we now suspect the assessment that a large rate cut may be needed, and sooner rather than later, was probably made on Friday, and that the delay until today had more to do with the time it took to bring the Committee to a consensus for “action not words,” and to bring the rest of the G7 alongside with likely additional non-monetary policy responses.

One last point is that these elevated probabilities of further rate cuts, or that the coronavirus effects may prove to be more sustained or structural in changed consumer and business spending decisions, means the pressure will be higher than ever for the FOMC to accelerate their much telegraphed Policy Framework Review.

And that, in turn, will mean the FOMC will need to move quickly from debating dovish language tweaks to the inflation target, and straight to mapping out its options with unconventional policy measures and, above all, sorting out the immensely difficult issues surrounding the operational relationship between the Fed and Treasury when fiscal policy is likely to take the lead macro policy role going forward, with monetary policy assuming a secondary, supportive role.

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