After a frenzied week of astounding market volatility and turmoil, and going into next week’s pivotal Federal Open Market Committee meeting, we would make three broad points to highlight our expectations for the Fed’s near term policy path and policy options we think are being weighed:
*** First, while a truly threatening systemic risk would trigger without hesitation an immediate rate cut, we are skeptical of the talk for another inter-meeting emergency rate cut before next week’s FOMC meeting. All else being equal, such a rate move would tend to muddy up the signals Fed officials hope to draw on what the liquidity moves this week are accomplishing. But more importantly, there may be a caution that a pre-meeting rate move could be easily misinterpreted and come off as panicky just days to the scheduled FOMC meeting. Waiting for the meeting will give the FOMC the means to maximize its punch through the guidance in the statement and presser, as well as packaging the cuts with likely balance sheet and targeted lending measures. ***
*** On the rate front, even amid the worsening outlook for a sharp economic downside shock, we are not sure the FOMC is entirely there just yet on a near certain market pricing for a 100 basis point rate cut that would bring the policy rate back down to the Zero Lower Bound. This will be a Board-driven rate decision, to be sure, but we think the FOMC majority is still assuming a 50bp rate cut as the base case, with aggressively dovish guidance to act further “as appropriate.” Our sense of reluctance to go the ZLB in one go is because there may still so much uncertainty over the depth and duration of the downside shock and when, if truth be told, the Fed is still scrambling to forge a consensus on their policy playbook once rates are flattened against the ZLB. ***
*** And on the balance sheet, we think an increase is likely in asset purchases from the current $80 billion a month, split between $20 billion in investments and the $60 billion in new asset purchases to increase the size of reserve balances. An increase in asset purchase to at least $75 billion and to as much as $150 billion a month is likely to be on the table, perhaps with a mechanism to be tapered if there is clarity on the outlook. Indeed, the asset purchases are likely to be extended well into the second half of the year. We are assuming an expanded QE will come in the Wednesday statement, but could come sooner if there is a sense balance sheet stresses need to be addressed before going into the meeting. ***
The Fed’s “Whatever It Takes” Moment
Despite our sense of caution across the FOMC about a 100 bp rate cut next week, we do get a clear sense under Chairman Jerome Powell’s stewardship, the FOMC has rapidly shifted into a defensive “whatever it takes” posture whose start was signaled in the inter-meeting 50bp rate cut last week – it feels ages ago – and continued in the massive liquidity interventions earlier today and yesterday.
The offered volumes of repo liquidity and the expansion of the asset purchases from bills to across the yield curve and to take lesser liquid assets from dealers only marks the start of what is shaping up into a sustained policy counter to the coronavirus downside shock. We think the Fed is determined to construct a sequence of measures to give momentum and maximum effect to an unfolding mix of monetary and balance sheet measures being targeted to both relieve market stresses and to cushion the coming pain in the real economy.
That said, barring a sharp systemic risk emerging, there is an inherent FOMC reluctance to commit to another inter-meeting rate move – with a meeting just days away — that would use up the remaining precious rate space. Doing so could muddy up the signaling they hope to glean from the effects of the liquidity measures already taken.
And more importantly, it could likewise muddle up the messaging distinction in the Fed’s two-front policy response to the current coronavirus crisis: liquidity and balance sheet measures to maintain a functioning credit market and a rate policy response that would be more directed at cushioning the real economy and the inevitable balance sheet damage that will become apparent from the collapse of spending and demand.
The Fed is clearly signaling there is still more policy response to come “as or if needed” after the last two days of repo and the tweaks to the asset purchases. That most of the huge repo on offer is being undersubscribed because the dealer/banks lack the balance sheet space is likely to be taken as evidence an expansion in the asset purchases may be needed as the quickest and most effective way to push dollar liquidity beyond the dealer community to where credit market strains are presenting potentially significant systemic risk.
Our sense is that additional “unconventional” measures like a resumption of the Term Auction Facility or a repeat of an Operation Twist, to sell bills into the market and especially to offer to buy off the run illiquid longer term securities are also being weighed. In addition, the Fed may be dusting off 2008 crisis era considerations in how to encourage bank lending to small businesses facing illiquidity but which are otherwise solvent, perhaps through relaxed capital and liquidity regulations. The dollar swap lines with foreign central banks are likewise available.
The Rates Scenarios
On the rate outlook, while a rapid descent to zero for the markets is fast becoming the highest probability outcome to the meeting on Wednesday, we would caution there probably isn’t anything like a consensus yet on whether to cut straight to zero in one move, and it may be unlikely to come together until the meeting itself. The collapse in inflation breakevens will be taken with alarm, to be sure, but we suspect the Fed will be reluctant to take it fully into the rate decision due to so much market illiquidity and volatility noise in any decent signaling takeaway. At least not yet.
The Fed is still quite keen to see what the scale, structure, and speed of fiscal stimulus by Congress may be forthcoming, as well as a better handle on how sustained the recent collapse of oil prices will be, and a deeper sense of its spillover into the US energy sector and its debt outstanding. The Fed districts are aggressively reaching out to their business and banking networks for as much anecdotal feedback as they can glean going into the meeting.
In an ideal scenario, we suspect the first preference of the Committee majority – though not necessarily its voting majority, a rather important caveat – would be fora 50bp rate cut as the base case on Wednesday, and if the market reacts by pricing in another 50bp, the Fed would probably be more than happy for the additional accommodation being priced into financial conditions until they can assess the extent and duration of the downside shock to the real economy.
That said, the Fed staff are highly likely to be penciling in sharply below trend growth, with a stall speed shock to real growth across the first half of the year that could still drive the economy into recession. The question may then become best estimate scenarios of how long and deep it may still prove to be, compared to our sense of the Fed’s base case outlook right now of substantial weakness in the first half of the year, to be followed by a fairly decent snapback to growth in economic activity and aggregate demand. This is clearly fast becoming a demand as well as supply shock, and both consumer and business behavior could see a substantial and extended downshift.
We doubt the rate dot plots and the Summary of Economic Projections will be dropped from a release on Wednesday, but we do expect the projections and rate dot plots to be presented with a huge grain of salt by the FOMC in terms of signaling the most likely rate path or even the consensus economic projection. The fan charts around all the projections, if they released the SEPs in that form, would probably be so wide as to make them more or less irrelevant until perhaps June.
An Unfinished Playbook at the ZLB
Another reason we are less certain than markets the FOMC will drop-kick the policy rate straight to zero is the lack of a worked-out policy game plan for policy at the ZLB. We cannot however discount how much progress might be underway this week by staff to come up with briefing papers for the FOMC to discuss at next week’s meeting, and we think the FOMC is indeed moving forward on two fronts regarding its recession fighting tools and shoring up its policy ammunition when they have exhausted the remaining rate space:
First there seems to be considerable momentum towards the embrace of a very aggressive forward policy guidance as a key policy tool at the ZLB, namely a very long “lower for longer” horizon on the likelihood of being able to begin lifting rates again. Depending on the severity of a downturn obviously but that “lower for longer” messaging could be central to the policy messaging for an extended time.
And to give the forward guidance some heft, we think a consensus has or will soon be forming up to frame the lower for longer messaging with an updated version of 2012’s QE3 Numerical Thresholds. In this case, the lead and safeguard thresholds will be reversed to staying flat on rates until the inflation rate has returned to its symmetrical 2% target or perhaps 2.5%,while the safeguard threshold would be unless the unemployment rate should drop below, say, 3% or even 2.5%.
The more potentially potent second leg of the ZLB playbook will be how the Fed undertakes QE, specifically, there will be little need, or opportunity to scale up large scale asset purchases to drive down the term premium and longer end yield levels, because the market will have already pancaked the curve to near zero if the US is in or approaching recession.
That is where the yield curve cap discussions enter into the policy equation: namely the Fed will signal its intention to use its balance sheet to purchase whatever it takes in treasuries to prevent the eventual steepening of the curve in order to extend a desired period of ample accommodation that should likewise see rising inflation expectations.
The reason Fed officials have so far only broadly hinted about the merits of YCC is that the missing link is the need for fiscal stimulus, potentially on a massive scale, to drive aggregate demand higher and to eventually begin steepening the curve again. That, of course, can only come from Congress and the White House.