Fed Note

The Federal Open Market Committee had no further policy moves to announce after their meetings this week. This follows lowering rates dramatically in March, to a minimum level of 0.00-0.25%, to counteract anticipated economic effects of the coronavirus. Other current tools being used include unlimited buying of treasury and agency mortgage-backed bonds, designed to keep interest rates contained to a desired low level. Extensive facilities are also in place to help provide liquidity for domestic fixed income markets and even some ETFs.

In their formal statement, the FOMC discussed the hardships from the virus, and disruptions caused. The zero-rate target is expected to remain until they’re ‘confident that the economy has weathered recent events’. With a limited set of policy tools remaining, the public’s confidence in their role in supporting the economy and financial markets as needed remains very important.

The metrics behind the key decision pillars have deteriorated sharply in the last month or two, from relatively strong to about the worst since the Great Depression of the 1930s:

Economic growth: From a level of 2.0% or so over the past several quarters, the engineered shutdowns to battle the virus are estimated to trim up to -5% from GDP in 2020 (and possibly an annualized -30% in Q2 alone). This morning’s report of -4.8% annualized negative growth for Q1 was slightly worse than expected—all due to conditions in March. The damage is severe, but dependent on the length of the underlying closures, with a ‘U-shaped’ recovery expected as conditions return to normal eventually, and barring a second wave, which could turn into a ‘W-shape’. Fed policy will no doubt depend on this progression, but options are becoming more limited.

Inflation: Price levels were running just below the 2% Fed target prior to the slowdown, with the most recent March CPI coming in at 1.5% for headline and 2.1% for core. The sharp crash in crude oil prices has caused a sustained drop in headline inflation, while core has been slightly less affected so far. But overall, a lack of consumer and business demand can have a downward effect on prices. The Fed is very sensitive to inflation readings and perception, due to their deceleration correlating to sustained recessions and negative consumer sentiment, which they fear could perpetuate downturns.

Employment: This is one of the most dramatic reversals one could imagine in the course of a month. From multi-decade low unemployment levels in the 3-4% range, the shutdowns mandated by state and local governments furloughed at least a tenth of American workers, from services of all types as well as manufacturing. Again, while these are expected to be temporary, the longer the shutdown period, the more severe the damage for small businesses and worker psychology. There are signs that certain parts of the economy will be reopened as soon as the next few weeks in some areas, which could lessen the damage from an extended period of inactivity and unemployment. But, this of course, remains fluid.

In looking at Fed policy, current economist estimates point to a likelihood of no rate changes for at least the next several years. This would place the current Covid episode similar to that of the Great Recession a decade ago in terms of policy depth and length. The Fed has taken deeper steps in this case, however, in their support of financial markets. This is particularly interesting in the areas of initially investment-grade, and now, certain high yield bonds, which is unprecedented. Some economists see the Fed’s mission as morphing from steering monetary policy to seemingly providing support for risk markets, which purists never could have imagined years ago, but follows the lead set by Japan and Europe where any asset is essentially fair game. Others see the actions as important in preserving the function of credit markets by ‘greasing the wheels’, so to speak, and preventing lockups in firms obtaining needed capital.

Those worrying about Modern Monetary Theory (MMT) and unlimited money printing coming to pass no longer need to fret—it’s already begun to some extent. No one has questioned the Fed and Congress about recent spending actions to keep the economy afloat during the time of Covid, but effects of this debt expansion in future years remains uncertain and untested. Long-term, there are also potential effects on capital allocation decisions if a ‘Fed put’ is left in place indefinitely.

 

Investment markets have already assumed the Fed will be keeping conditions eased for the foreseeable future. If this policy remains anything like the financial crisis, it will indeed be years. This is not great news for cash savers and bond investors in many cases, where low rates provide few viable options and a decent amount of ‘return-free risk’. For equities, near-zero interest rates can push fair valuations far higher, which rewards risk assets, evidenced by the sharp snapback in recent weeks. At the same time, it also (again) raises potential risks of overvaluation or asset bubbles down the road.

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