Fed: Holding the Line, For Now

Published on February 28, 2020

Against the backdrop of a continued freefall in equity markets this morning, we took the remarks from Little Rock by Federal Reserve Bank of St. Louis President James Bullard as an important signal that the Federal Open Market Committee consensus is holding firm, namely, to patiently wait for signs of credit market structural fragility and clearer data on how sustained the downdraft from the coronavirus is likely to be on demand and inflation before taking any potential action on rates.

** A brutal stock market plunge of some 12-13% in a week is of course seizing the attention of Fed officials, and we would not be surprised if an FOMC inter-meeting conference call is arranged this weekend. But that said, unless the credit markets are truly seizing up – and for now, they are not – we believe a rate cut, certainly an inter-meeting cut, is still far from certain. Our sense is that the FOMC, for one, is very sensitive to moral hazard concerns in responding to a stock market correction with rate cuts when the impact on inflation and real demand is still uncertain.

** Bullard hardly “speaks” for the FOMC, but he has in the last year or so come to consistently reflect the center of the Committee consensus, and his stressing patience on the Fed’s rates stance while leaving the door slightly ajar if the effects of the coronavirus do indeed worsen or turn into a true pandemic is telling. His remarks were likewise echoed in the caution offered by Dallas Fed President Robert Kaplan, and by Cleveland’s Loretta Mester, both stressing that the Fed’s options will be left open, but the focus for now is on gauging longer-lasting economic effects.

** And at least until now, last year’s rate cuts coupled to the lifting of the trade tariff threats had been underpinning a fairly respectable above trend growth in the US economy, with housing and the still solid labor market in particular providing a strong foundation to consumption. That could change, obviously, if continued freefalls in the equity markets look to be cutting into consumer confidence, or consumption and economic activity start to wobble if (as) the coronavirus spreads more broadly across major US urban centers. But almost by definition, that would put the FOMC decision on its rate stance into the March 17-18 meeting.

** We would add that to get a Committee consensus for a rate cut, it would probably need to include a commitment to “take back” the accommodation if the damage to the economy proves to be less than feared in the next few months. And indeed, the Fed’s ability to actually raise rates any time soon, in an election year, or when it is already struggling to convince the markets of its tolerance for an overshoot of the symmetrical 2% inflation target would put the credibility of any such vow in serious doubt; another reason then, to “lag the data” rather than embrace what would look like a market-driven pre-emptive rate cut.

** If the stock market declines stabilize sooner rather than later, and assuming the credit markets are still holding up, we still think the base case remains a March meeting repositioning of the policy stance to the possibility of a rate cut or cuts through more dovish statement language and a further downshift in the rate dot projections – which was likely in any case in the run up to the June meeting unveiling of the Policy Framework Review. A rate cut, of course, would likewise be on the table, but again, supporting data will need to be there to provide credible justification.

** We would also be cautious about the likelihood of global coordination on moves by the G7 central banks. For one, the Fed is essentially the only central bank with any significant capacity to cut rates, so short of “moral support” from the other central banks endorsing a Fed rate cut, we think it unlikely. Bank of Japan officials, for one, have pointed already to the fiscal side as a more appropriate response, and ECB officials, despite even more significant downside risks to the Eurozone, have signaled a hesitation to move yet, at least in March. Something in a coordinated fashion could be done through renewed balance sheet expansion, but again, a rush to that playbook again just now could risk a signal of impotence rather than muscle. If there is to be any global coordinated policy response, we suspect it will have to come with renewed calls for help from the fiscal side, and we doubt that will be forthcoming on a global scale under any realistic political timetable.

** And one last point we would stress again is that a key trade-off in a more cautious, lagged reaction function to the current market turbulence and heightened downside growth and inflation risks is that if the FOMC concludes further accommodation is warranted, it means the rate cuts will invariably be larger than it they were to be more pre-emptive. That would point to an initial 50 basis points rate cut rather than, say, a string of smaller 25 bp cuts. The Committee would also then not necessarily need to wait for a scheduled meeting, as Chairman Jerome Powell could be given the leeway for an inter-meeting rate move if deemed optimal to extending the expansion.

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