Today the Federal Reserve cut its benchmark interest rate by 50 bps. The FOMC’s accompanying statement said that the committee is “closely monitoring” developments and will “act as appropriate” going forward. In the subsequent press conference Chair Powell reviewed all of the obvious reasons for today’s action, but he refrained from giving any guidance on where things are headed from here.
Looking forward we’d make the following three observations regarding Fed policy and markets.
First, the speed and decisiveness of today’s Fed action reflect both the economic seriousness of the ongoing coronavirus/COVID-19 situation, as well as the Fed’s proactive stance when it comes to supporting the US economy. With regard to COVID-19, we believe it is now clear that there will be a significant impact on global economic activity. Most forecasters have lowered expectations for global growth to close to zero in 1Q20, and the outlook for 2Q20 remains quite unclear. We think it is straightforward that the Fed should respond to such a sizeable shock to economic activity. (While some observers may complain that monetary policy is ill-suited to respond to a “supply shock,” it seems that there is an element of demand shock going on as well. The Fed rightly isn’t waiting to find out which one is dominant.)
With regard to the Fed’s proactive approach, its messaging on this point has been clear for a while. As the Fed understands, the risks are elevated when growth, inflation and interest rates are all at low levels. In such an environment, we believe monetary policy should be proactive and aggressive in order to support growth and avoid levels moving even lower. Today’s actions are evidence that the Fed believes this argument and the FOMC is unanimous in supporting the actions that this argument demands.
Second, the relationship between Fed actions and the market outlook may be weaker than normal in the very near term. The market’s response to today’s Fed action was telling. The Fed’s cut came earlier than most expected and at least met expectations in terms of sizing. What’s more, nothing in Powell’s comments could be considered disappointing or hawkish. To the contrary, Powell struck a dovish tone in terms of the risks to the outlook and he refrained from suggesting that today’s cuts would be immediately taken back should the threat of the virus subside. In short, today the Fed met or even exceeded expectations, and any arguments to the contrary are difficult to credit. And yet, by the end of the day risk markets had moved lower, breakeven inflation moved lower and bond yields moved sharply lower across the curve. Needless to say, this is not the normal behavior for markets in response to the Fed meeting or the Fed’s actions exceeding expectations.
The reason for the abnormal market response is that investors are struggling to assess the outlook for COVID-19, and the risks of either further spreading or further economic impact. As long as the COVID-19 risks remain front and center, the relationship between Fed actions and market responses may remain difficult to predict.
Third, and perhaps most importantly, while the Fed may not be the most important factor in determining near-term market moves, we do believe that the Fed is taking meaningful actions that will, over time, have a real impact on the economic outlook and therefore on markets. In particular, the Fed’s proactive move to a more accommodative stance will support economic growth, and could even be decisive for the inflation outlook.
The precise way in which this plays out depends crucially on the path of the COVID-19 impacts. Should the COVID-19 impacts prove deeper or more prolonged than currently anticipated, the Fed will likely continue to cut rates, perhaps as early as the March or April FOMC meeting (the market is already priced for another 50 bps of cuts through June). In that case, the Fed’s lower rate policy will support sentiment and financial markets, not to mention real activity through increased liquidity and lower lending rates. On the other hand, should the COVID-19 impacts turn out to be more moderate, the Fed’s rate cuts could leave monetary policy in an accommodative stance at the same time that a recovery from the COVID-19 slump is propelling growth to above-trend levels. Above-trend growth and easier monetary policy could in turn lead to a quicker recovery in inflation toward the Fed’s 2% target. This would be an entirely new environment for markets, or at least an unfamiliar one for investors now accustomed to a steady drumbeat of ever-lower growth and inflation forecasts.
A lot hinges on which of those two paths the COVID-19 impacts take. Today’s market moves suggest this will be the most important thing for markets in the near term. But, over the longer term, the real economic impacts of the Fed’s actions will matter. And accordingly, markets are more and more likely to be influenced by a proactive and accommodative Fed, especially if that is eventually combined with an economic rebound.