'Monetary policy isn't a panacea' - Moody's Analytics

Ryan Sweet, Head of Monetary Policy Research at Moody’s Analytics notes: “The Federal Reserve needed to step in. However, monetary policy isn’t a panacea. The intra-meeting decision is rare and risky, since it could be viewed as the central bank panicking, and financial market conditions may not respond as well as the central bank anticipates. The Fed’s rate cut would pack the biggest punch if it creates a sense of urgency among fiscal policymakers to act.”

United States: FOMC Monetary Policy

Analysis by Ryan Sweet, Head of Monetary Policy Research

Behind the Numbers

COVID-19 poses downside risk to the U.S. economy, and though there are limits to monetary policy, the Federal Reserve needed to step in. Monetary policy has limited power in addressing supply shocks. But financial markets view COVID-19 as a demand shock, which is disinflationary. Also, the Fed has recently shown that it will respond more quickly to an inversion in the yield curve, and the cut could help bolster investor sentiment and put a floor under asset prices. This may not cure all that troubles financial markets, but it could help. Still, we believe the key is not equity but rather credit markets. Making sure credit markets don’t freeze is critical.

Monetary policy isn’t a panacea and the intra-meeting rate is risky. This could be seen as a panic move and the Fed’s desired impact of the rate cut could not materialize. Financial market conditions may not stabilize as markets will remain sensitive to the news flow about the spread of COVID-19, the Fed doesn’t know how that will unfold. Also, the Fed rate cut won’t alter consumers potential risk aversion, which will hurt brick and mortar retailers and leisure/hospitality. Leisure and hospitality workers are also least likely to have paid sick leave and health care.

The Fed’s rate cut would pack the biggest punch if it creates a sense of urgency among fiscal policymakers to act. The Fed will likely cut again but they can pull other levers. It’s possible that ease credit standards on banks. There is flexibility in the Fed’s guidance to banks during natural disasters, allowing them to provide temporary relief to borrowers under the Community reinvestment Act. The Fed could use forward guidance, signaling they will keep rates low for an extended period of time and/or use quantitative easing. QE will likely pack less of a punch as long-term rates in the U.S. are already near record low.

Fed funds futures put the odds of a 25 basis point cut in the target range of the fed funds rate in April north of 60%. Odds of rates being lowered to 0% by the end of this year are only 5%, according to fed funds futures. Odds are the Fed will error on the side of being aggressive as they want to keep the expansion going and there isn’t any immediate concern about inflation.

We will likely incorporate at least one additional rate cut in our March baseline. The path of the 10-year Treasury yield will also need to be adjusted. Our forecast for GDP growth in the first half of this year will be cut noticeably and the Fed’s cut today won’t have any barring on economic activity in the first half of the year as changes in monetary policy impact the economy with long and variable lags.

The Numbers

• In a rare move, the Federal Open Market Committee opted not to wait for a regularly scheduled meeting to adjust interest rates. It lowered the target range for the fed funds rate by 50 basis points to 1% to 1.25%. This is the ninth intra-meeting rate change since 1994. Emergency rate cuts since 1994 haven’t provided a big boost to equity markets.
• The risk posed to the economy and financial markets from COVID-19 led the Fed to lower interest rates. Financial market conditions had tightened, and access to credit has become impaired. The spread between the 10-year and three-month Treasury yields had inverted more deeply.
• The timing of the decision will be heavily debated. In fact, it could backfire, as it could fan fears that the central bank knows something markets don’t about the economic cost of COVID-19, because policymakers had been saying they wanted to see hard evidence the U.S. economy was being affected.
• The Fed may have been viewing COVID-19 as a supply shock because of the disruption to global supply chains. Monetary policy has limited power in addressing supply shocks. But financial markets view COVID-19 as a demand shock, which is disinflationary. Market expectations for the consumer price index over the next year have dropped recently, and the 10-year Treasury yield is near historic lows. To help address a possible demand shock, the Fed likely needed to act quickly and aggressively.
• Another possible rationale for the cut and its timing is to stabilize the collective psyche. A deterioration in the collective psyche could cause U.S. economic growth to slow even more abruptly this quarter and next as COVID-19 causes consumers to adjust their behavior. Therefore, we are paying close attention to measures of consumer sentiment. The Fed knows that the consumer has been carrying the economy. Excluding consumption, real GDP has fallen in two of the past three quarters, suggesting there are few supports to growth apart from the consumer.
• The post-meeting statement was brief. It noted that the fundamentals of the U.S. economy remain strong. It said that the coronavirus poses evolving risks to economic activity. The statement also included that the FOMC is closely monitoring developments and their implications for the economic outlook and will use its tools and act as appropriate to support the economy. There were no dissents.

You May Also Be Interested In

• Wolfe Research sees oil prices holding steady amid US-Iran standoff
• Gartner (IT) PT Lowered to $206 at BMO Capital, adjusting estimates
• SmartFinancial (SMBK) PT Raised to $60 at Benchmark on Higher Valuation