Fed: The Near-term Reaction Function

Published on February 26, 2020

The stock markets dropping by nearly 7% in two days and safe haven buying flattening yields to record lows has brought a hyper focus to how and how soon will the Federal Reserve respond to the deepening gloom over the coronavirus downside risk to US growth and inflation.

*** For all the volatile market movement in recent days, the Fed’s reaction function is far more likely than not to be lagged behind the coming data rather than pre-emptive in the way it is being priced by the markets. Barring a dramatic seizing up in the credit markets or an unprecedentedly sharp escalation in the spread of the coronavirus – major caveats to be sure – there is almost no chance of an imminent rate cut by the Federal Open Market Committee, with a very low probability of a rate move at the March FOMC meeting three weeks from today, at least under current assumptions. ***

*** We think a more likely scenario by the time of the March meeting is more dovish descriptive language in the formal statement that leaves the door ajar to a potential rate cut, while the expected effects of the coronavirus or other downside risks would be reflected in downgrades to growth and core inflation projections. Equally noteworthy will be a likely further flattening of the rate dot projections, in part because the Committee is moving towards a fuller consensus on a “lower for longer” rate guidance that will be given a more formal shape in the June policy framework review. ***

*** That said, a lagged response to what could still prove to be a sustained L-shaped negative shock to the economy almost by definition elevates the scale of an easing if deemed warranted: so while the prospects for a rate cut are relatively low between now and, say, the April meeting – and the June meeting agenda is already overloaded – the odds are significantly high for a 50 basis point rate cut or even more the longer it takes for a Committee rate consensus to stabilize or reverse the negative feedback loop of weakening data, eroding consumer confidence, and falling aggregate demand if these do indeed materialize. ***

Reasons to a Lagged Policy Response

The main reason for a fairly lagged reaction function in the current environment is fairly obvious and already telegraphed by several Fed officials, namely, that the risks to the US economy in the coronavirus, or COVID-19, are still so highly uncertain, and for now, limited to financial market swoons rather than real economy demand.

The outlook will become that much clearer, one way or another, within a month or more. To gauge the damage to global growth and where, when, and to what extent it may spill over into US demand and prices means waiting to see some data well into March and through perhaps May to gauge whether the COVID-19 effects are showing through in the monthly source data like sales, shipments or orders.

Imperfect and noisy data like high-frequency initial claims and consumer confidence indicators are especially being monitored. There is some bated breath in waiting to see whether the dramatic “prepare for the worst” remarks by the CDC yesterday may stoke a consumer confidence shock and a premature pullback in spending that goes beyond a still tentative reluctance to say travel or dine out on the margins.

But again, the same rule of thumb applies: to wait until well into March and April, even May to gauge the impact on the real economy. Otherwise, it would be simply too early to gauge what the impact of a monetary easing would be.

Another perhaps less explicitly stated reason to lag the reaction function is the highly undesirable moral hazard message to financial markets in responding too quickly at the first drop in asset prices, even if brutal and sharp. If truth be told, barring an extended equity market freefall that threatens systemic risks, most Fed officials are invariably a little relieved that some of the one-way complacence, if not froth, in equity prices is coming off in a return to price discovery.

“It’s not surprising that you can get some reversal,” Federal Reserve President Robert Kaplan observed yesterday in gently underlining this exact point. “It’s always worth noting where we started before this situation occurred.”

Indeed, ideally, the central bank would like to wean the markets off expecting a monetary policy bailout to every sharp downturn, and in this case, officials may stress rates are too blunt an instrument to wield in response to the initial virus effects and point instead to better suited fiscal or other Administration policy responses to counter contagion.

And there is finally a secondary, but still critical reason to a lagged policy reaction function: the FOMC consensus since the October meeting rate cut and messaged pause going forward is still very entrenched across the Committee, and we suspect it would take a major market or economic dislocation to jar the FOMC into rate action.

Not to belabor the point, in fact, but the current rush of pressure to cut rates at the first evidence of economic and especially market volatility neatly underscores the argument pressed by the Committee hawks opposing last year’s rate cuts: wait until there is actual downshifting data pointing to below trend growth or below desirable inflation before using up precious rate space above the Zero Lower Bound.

Against that backdrop, we would not be surprised if at least some Fed officials argue the Fed last year already provided the economy with an “insurance” of accommodation that cushions the current tail risks to the outlook. In the meantime, credit markets are functioning, consumers are still spending (for now), and the central bank needs to let markets operate.

And finally, in the same vein of analysis, lower yields are not, for now, being taken as an alarming indication monetary policy is too restrictive for the real economy. And, in fact, the lower yields are providing an “advance accommodation,” through the housing channel for instance, that may or may not need to be validated in a rate cut, depending on the signals drawn from incoming data about changes to the base case forecast.

Reifscheinder-Williams Remains on the Table

But all that said, there is still a not insignificant probability for a rate move later this year IF there should be a perceived “material reassessment” in the Fed’s base case forecast.

And because the reaction function will tend to be lagged in following confirming data rather than being pre-emptive, that policy posture will invariably point the FOMC to weighing the so-called Reifschneider-Williams playbook – so named after the seminal 2000 paper by two Board staffers – of “swift and aggressive” rates cuts when so near the Zero Lower Bound to maximize the punch of the limited rate space with the policy rate currently at 1.5%-1.75%.

Against that calculation, for all their disdain for conceding too much of an influence, Fed officials will indeed be closely assessing the behavior and sustained looking price trends in financial asset prices indicating whether the economy’s current momentum is downshifting; if it is, the feedback loop into consumer confidence and spending – the main driver to the current above trend growth due to the no show of business investment spending – can be rapid, and severe.

And while of course an unobservable data point, by most accounts, the Fed would be looking at a drooping short run r* estimate, which would be pointing the Committee to the need to cut rates to stay as accommodative as they can, while hoping Congress and the White House would be stepping up to take the lead in the policy response.

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