Go Big or Go Home

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MARCH 16, 2020  

By Tim Duy 

In an effort to keep financial markets from spiraling out of control, the Federal Reserve came out with the big guns Sunday afternoon.This will not prevent the economic downturn that is already upon us. It will, however, create more accommodative financial conditions that will help support the eventual recovery. In the near term, however, the Fed’s action will – hopefully – support smooth functioning in financial markets and ensure that the problems on Wall Street do not feed back onto Main Street. The Federal Reserve has now passed the ball to fiscal policy makers, at least for the time being. This doesn’t mean the Fed is done; Powell & Co. have more ammunition if needed later.

Quick summary of the Fed’s actions today:

Cut policy rates to 0%-0.25%. Back to the zero bound all at once. It was the Fed’s only choice.

Forward guidance. The Fed committed to holding rates near zero “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

Quantitative easing. Federal Reserve Chair Powell didn’t call it quantitative easing, saying instead the label doesn’t matter as long as it gets the job done. Fed will be buying $500 billion of Treasuries (presumably across the curve as the New York Fed signaled last week) and $200 billion of mortgage backed securities.

Discount rate cut to 0.25%. This is kind of a big deal, basically drops the discount rate to the overnight rate to take the stigma out of using the discount window (they really want this stigma gone). Plus, banks can borrow from the window for up to 90 days.

Intraday Credit. Fed wants banks to use its intraday credit programs.

Loan guidance. Fed signals that banks should use their liquidity and capital buffers to lend to household and firms. The Fed is telling banks this is the time to use those buffers.

Reserve requirements. Fed eliminates reserve requirements, which were pretty much irrelevant in a system of ample reserves.

Powell made very clear in the press conference that the Fed’s objective is to support the smooth functioning of financial markets. In particular, the Fed is reacting to the liquidity problems that crept up in the Treasury and MBS markets last week. Powell explained that the Treasury market is the foundation of the global economic financial system and keeping it functioning was the Fed’s primary objective. The MBS market is critical to keep credit flowing to households.

Powell said he expected the second quarter to be very weak but had little confidence in forecasts beyond that. It depends on how the virus evolves. He rightly noted that the rate cuts would not have an immediate impact on the economy, but will support the rebound in activity on the other side. He highlighted the role of fiscal policy in moving targeted aid to individuals and firms directly impacted by social distancing measures. To my ears, he wasn’t yet convinced of the need for a bigger fiscal stimulus, though I think this was because he wasn’t yet confident the downturn would last more than a quarter.

With regards to his own health, he has not been tested for the virus, he feels healthy, and he is doing some teleworking.

They will not be meeting again this week as originally planned. There will not be a Summary of Economic Projections. Powell said the forecasts would be pretty useless right now. And thankfully we then aren’t faced with the prospect of any “hawkish” dots in the 2021 rate forecasts.

Inexplicably, Cleveland Federal Reserve President Loretta Mester dissented against the rate cut, preferring instead just a 50 basis point cut. I await her explanation; I hope it isn’t about “saving ammunition,” which would be pointless argument now. I don’t see much percentage in trying to emulate a Richard Fisher or Thomas Hoenig in this crisis.

The Fed shot a lot of bullets today, but they are not yet out of ammunition. Most of today’s policy moves were designed to support market functioning, not the economy directly. They can do more on both fronts. For example, regarding market functioning, they can expand the size of asset purchases or, if needed, develop 13(3) emergency lending programs. Note that the asset purchases were of a fixed amount. The Fed could switch back to an opened commitment and link it via forward guidance to explicit economic objectives. They can follow up with yield curve control. Then there is the possibility of regime change toward average inflation targeting, etc. That said, in the near term we really need fiscal stimulus. The Fed has paved the way, but they can’t make Congress and President follow their lead.

Financial markets did not exactly cheer the Fed’s move; equity futures limited down, setting the stage for another difficult day on Wall Street.This should not be unexpected. I don’t see the possibility of any near-term stabilization in financial markets until we get more clarity on the challenges we face. This week reality will be settling in as much of the economy is going to be shut down. Testing will expand and the confirmed cases will grow. So too will the number of deaths. I don’t see where the Fed can do much more than keep financial markets functioning in this environment. This is important to sustaining the free flow of credit; crippled credit markets would only make the downside worse. But until we get enough testing, mitigation, and containment to bend the curve, market action will retain that distinctly bearish mood.

Bottom Line: The Fed realized this was a “go big or go home” moment, and it rightly decided to “go big.” The Fed basically signaled as clear as it could that it was ready to backstop the financial markets. I am thinking Powell is not going to let another Lehman Brothers happen on his watch. The Fed can’t, however, keep the economy from diving into a hole in the second quarter. Market sentiment now is probably going be driven by the prospects for fiscal stimulus.

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