The Fed goes all in
MAR. 16, 2020
Sunday evening’s announcement by the Federal Reserve of a 100 basis point cut in the target federal funds rate range (to the zero bound), $700 billion in purchases of Treasury and mortgage-backed securities, easing of borrowing standards at the Fed’s discount window, cutting reserve requirement for banks to zero, and enhancing worldwide dollar liquidity through actions coordinated with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank, indicates that the Fed has gone all in in an effort to mitigate the negative impacts on the economy and the functioning of financial markets in response to the COVID-19 pandemic.
Easier monetary policy — even combined with expansionary fiscal policy — will not be able to stop the spread of the coronavirus, nor is it likely to stop economic growth from slowing in the near term. But financial markets last week showed significant signs of strain — as they did in the fall of 2008 — and the Fed and other central banks are stepping in an aggressive manner to try to mitigate these negative impacts.
Importantly, Fed Chair Powell stated that the Fed was prepared to do more if necessary — so yesterday’s moves may not be the last if financial markets need additional assistance. And he also stated that negative interest rates were not among the Fed’s preferred policy tools. As a result, if the Fed does more in coming months, taking the target federal funds rates below the zero bound will not be done.
We expect real GDP growth in the second quarter to drop sharply in the U.S. — with annualized growth around -4.5 to -5.0 percent — as consumers and businesses cut back (often in response to state and local government mandates put into place to reduce the transmission of the virus). If the virus starts to abate by this summer, growth in the third quarter will still probably be negative, but not significantly — and the economy should rebound in the fourth quarter and into 2021 at an above-trend pace with lower interest rates and make-up spending. Without the Fed’s actions, the drop in economic activity would likely be far more severe.
We expect this lower level of policy rates to be sustained well into next year, even as the economy rebounds, as the Fed will want to be sure that expansion is maintained in 2021 — and to be certain that eventual rate normalization does not occur before the economy is ready for higher interest rates.