Is the ‘Powell put’ back?

The Federal Reserve (Fed) surprised us all yesterday when it cut interest rates by 50 basis points, two weeks ahead of its next scheduled meeting.

The announcement followed a G7 statement earlier the same day in which finance ministers and central-bank governors from that group of advanced economies committed to supporting the global economy through the coronavirus outbreak. Markets had already begun to price in some stimulus, but nobody expected such a swift decision from the US.

The Fed’s accompanying comments were brief, noting that “the coronavirus poses evolving risks to economic activity” and confirming that it would “use its tools and act as appropriate to support the economy”.

In a short press conference, the Fed’s chair Jay Powell expanded a little. He recognised that monetary policy can’t address the supply-side problems from the virus, but argued that monetary policy could be effective in boosting confidence in the private sector and in offsetting any tightening in financial conditions.

Powell acknowledged that the Fed was acting early, but highlighted some anecdotal accounts of weaker demand in sectors such as travel. Global corporations like Apple have already warned of disruptions in their supply chains too. The Fed was willing to move before seeing evidence of any slowdown in lagging indicators and data.

Cut loose

Some will infer panic from the Fed’s decision and dismiss it as likely to be ineffective in dealing with the current challenges. Indeed, within hours US equities were back in the red and the 10-year Treasury yield was below 1% for the first time in history – hardly a ringing endorsement of the cut. As Lars has explained, such a reaction isn’t unusual.

Yet we should remember that this Fed has little tolerance for asset-price declines or any event that threatens economic growth in an environment where the central bank has persistently undershot its inflation mandate.

Powell did not mention inflation expectations in his press conference, but we know the Fed is concerned about the potential for them to become unanchored. If this did occur, it would limit the Fed’s ability to respond to shocks such as the present ones.

Indeed, the Fed’s own research indicates that when faced with the risk of being stuck at the effective lower bound, monetary policy should respond earlier and more aggressively than in a more normal interest-rate environment.

So if we see signs that the spread of the virus is impacting demand, and in the absence of a loosening in financial conditions, it seems likely that the Fed will cut again at the next scheduled Federal Open Market Committee meeting on 18 March. It could well take rates all the way to zero if the situation deteriorates rapidly. Historically, the Fed has tended to follow emergency cuts with further policy action.

At the press conference, Powell was not drawn on what further action the Fed might take and offered no advice on fiscal policy. The Fed’s likely options beyond cutting rates to zero nonetheless include the scope for a large quantitative easing (QE) programme and the introduction of lending facilities to businesses if they suffer liquidity problems as a result of the coronavirus.

Yesterday’s cut may have been a surprise; further stimulus efforts would not be. We have discussed this possible 'Powell put', whereby the Fed comes to the rescue of markets whenever they suffer a bout of anxiety, in the past.

We also know the Fed will be slow to reverse course if the impact of the virus on the economy is not as bad as feared, with its governors probably wanting to see inflation breakevens rising by between 50 and 100 basis points to consider hiking rates.

This dovish stance could set up the US economy for a strong rebound later this year and an eventual overshoot, assuming the virus fades over the summer.