What Just Happened? Fed Cuts Rates

One of the fourteen had room and flexibility, and he, Federal Reserve Chair Jay Powell, went back to his office and used it. The Federal Open Market Committee (FOMC) announced, “The coronavirus poses evolving risks to economic activity. In light of these risks and in support of achieving its maximum employment and price stability goals, the Federal Open Market Committee decided today to lower the target range for the federal funds rate by a half percentage point, to 1 to 1 1/4 percent.” The FOMC ended the statement with the same promise Powell offered in his unscheduled statement last Friday that it “…will use our tools and act as appropriate to support the economy.”

Ending the statement on the same point from Friday that foreshadowed a 50-basis-points cut on Tuesday rightly leads markets to price in another same-sized move at the upcoming FOMC meeting on March 18. They might do less but their policy reaction function is indistinct right now. Recognize that the political calendar makes it extremely unlikely the moves would be reversed this year, despite the Fed Chair’s protestations. That is, the Fed most likely owns at least a one-percentage point lower funds rate this year.

I am at a loss to justify a sustained and substantial lowering of the policy rate begun two weeks before a regularly scheduled meeting and in the shadow of a politicized G-7 conference call.

• What about the “v”? The standard rationale for going quickly and by a large amount is to counter a persistent adverse hit to aggregate demand that threatens to bring the zero lower bound to nominal interest rates back into play. The coronavirus is still expected to impart a v-shaped dent in global activity—albeit a deeper and more asymmetric one than previously thought. Moreover, as a mostly closed and service-centric economy, the effects on the US are expected to be muted. The funds rate appropriate for the downward leg is not the same as for the upward one, a particular problem if funds rate cuts cannot be rolled back anytime soon.
• What about the nature of the shock? Both supply and demand fall in response to the real shock of a pandemic, presumably the first more than the second because households can use other resources to keep up spending even as income constricts. Output declines and cost pressures pick up, posing opposite threats to the Fed’s dual mandate. A central bank cannot make extra output or restore lost wealth. The standard advice is to keep the nominal funds rate unchanged.
• What about uncertainty? Elevated uncertainty about the position of the economy is not typically a rationalization for action unless there is a decided skew to potential outcomes. The “evolving risks to economic activity” that Powell described last week must have morphed remarkably quickly to prompt decisive action. If the uncertainty is about the transmission of policy changes through markets, then the classic advice is policy attenuation, or going slower, not faster, in changing the policy rate.
• Why between regularly-scheduled meetings? The FOMC has historically been reluctant to move between meetings on the fear that (1) it looks panicky; (2) it conveys a concern about the economy from some “insider knowledge” that is usually not warranted; (3) it feeds suspicions that the Fed is responding to equity-market moves; and (4) it feeds suspicions that the Fed was influenced by political actors. Going four-for-four is a good night in baseball but not for a central banker ticking off this list. Powell was underwhelming in his press conference, suggested the possibility that business contacts were part of the reason for marking down the outlook, acted the week after an 11 percent selloff in major equity indexes, and announced action by his committee within moments after returning from Treasury Secretary Mnuchin’s office.

The Fed should also be concerned about the efficacy of its action. A central bank does not make extra output, it borrows it from the future by moving the funds rate below its equilibrium and from its trading partners by depreciating its currency. As for the former, the implicit (albeit confusing) Fed rationale seems to suggest that the equilibrium real rate moved down at least as much as the actual one. As for the latter, Powell hinted that his colleague central bankers would also ease—limiting the scope for the dollar to depreciate. As of now, other central banks have not followed through and Powell is the nail that sticks out.

For a time, a series of unfortunate events should break the Fed’s way. As the infection spreads around the world, the news on confirmed cases and fatalities will be grim, even as cases top off in China. We are also entering the time frame in which data should roll over from the disruption in economic activity, the downward leg of the “v”. The problem posed for Powell is precedent. The Fed owns the “Powell Put” and any downdraft in equity prices will be mirrored in expectations for the policy rate, with all the implied worsening of moral hazard. The upward leg of the “v” will show policy to be mispositioned, leading to awkward questions about his original motivation.