If it seems members of the Federal Open Market Committee have been unusually disciplined in their policy messaging over recent weeks, there is a good reason:
** There is little to no appetite across the Committee for a near-term rate cut, a carryover of the consensus since the October meeting that last year’s three rate cuts will be providing more than ample accommodation to the real economy. So while the bar to a rate cut remains far lower than that for a hike, barring a sustained and substantial downturn in either growth below trend or an unexpected decline in inflation or inflation expectations, the bar to a near-term rate cut is higher than may be hoped for in markets.
** The Covid-19 downside risk is clearly adding a foreboding sense of caution to the Fed’s base case outlook, but the Fed is likely to adopt a “see-through” stance through probably at least the March FOMC meeting, with the risks seen as more “transient” rather than sustained. And there is, for now, no Committee consensus for a pre-emptive rate move to get ahead of any weakness in the economy. The Fed’s reaction function is thus more likely than not to lag behind confirming data that US growth or inflation is slipping below trend or the forecast.
Covid-19 Impact Still Uncertain
The extensive efforts by Chinese officials to bring the virus under control are clearly having a significant near-term impact on Chinese growth and import demand, which is already rippling across commodity exporters or high export-dependent economies like Japan and Germany and upending global supply chains.
The question for the Fed, and for the other major central banks, is essentially the same as for the markets: how soon will the spread of the virus peak or spread beyond China, and will its effects be lasting beyond a few months of contraction in Chinese demand, imports, or disrupted production in global supply chains. The coronavirus risks will certainly make their way into the litany of risks cited in the January FOMC meeting Minutes released tomorrow, which may add to the market’s dovish takeaways. But Fed officials will remain cautious in messaging any policy signals other than a close monitoring of developments,
For one, the impact of the virus and Chinese shutdown on the US economy is still unclear both in scale and direction. The disruptions to supply chains could nudge prices higher, for instance, or the need to restock stretched inventories at each step of the supply chain could lead to a rise in output. But comparable to the effects of the Asian crisis in the late-1990s, product prices could weaken.
Capital inflows into safe haven treasuries will invariably flatter the dollar, limiting any upward price pressures, and flatten the US yield curve. And that could ease already easy US financial conditions even further, which could make the Fed reluctant to stoke financial asset prices higher when the benefits of a further easing in monetary accommodation on the economy are still uncertain.
For now, however, the FOMC is still betting there is enough growth momentum to keep the economy “in a good place,” with housing, job creation, a prized rise in the labor participation rate, and last year’s accommodation all pointing to a continued above trend growth and, all else being equal, an optically encouraging uptick in inflation back towards the 2% target as last year’s weakness falls out of the data.
In any case, Fed officials are more or less betting the uncertain effects of the Covid-19 epidemic, or Boeing’s problems for that matter, will clear up one way or another within a month or two, putting the end of April FOMC meeting rather than March into the more likely timeline to weigh a policy response.
And even if the near-term effects should prove worse than feared, as we noted, the FOMC’s first instinct is likely to “look through” its impact on growth and inflation, much like an oil price shock, on the assumption economic activity will be reverting to its mean path in too short a timespan for monetary policy to have any meaningful impact.
Watching Short-run R*
All that said, however reluctant or resistant the FOMC may position itself in its coming meetings or messaging to a rate cut, its assessment of the outlook or a return to a more risk management approach to its policy calculations cannot be entirely dismissed.
For one, US growth does remain a bit too bifurcated and lopsided, with manufacturing still soft and the US consumer spending accounting for all the momentum. And there remain pockets of concern in some quarters of the Fed that even before the added downside of the Covid-19 risks, consumer momentum could start to ebb with growth slipping back below trend, or perhaps worse for Fed officials as they weigh the final drafts of their policy framework review, inflation may not rise back towards 2% as expected in the first half of this year or inflation expectations could unexpectedly drift lower.
And now with the Covid-19 uncertainties, even if the US economy is more insulated and in better shape than Japan or Europe, its resilience remains vulnerable to a potential deepening yet again of global risks.
Perhaps more to the point, any notion of a rate cut, if one were to reach the table of FOMC meetings this year, would be less about a proactive boost of accommodation to stimulate higher aggregate demand or capex, and more about chasing a downward drift in the short run r* to avoid making things worse with policy no longer as accommodative as needed.