The Fed cuts rates in emergency move, but investors were not impressed
The Fed cuts rates by 50 basis points in an unexpected move, signaling it is prepared to do more should the coronovirus spread further, as most analysts expect a further 50bp of cuts by the end of the second quarter.
Last friday’s statement that the Federal Reserve is “closely monitoring” developments and stands ready to “use our tools and act as appropriate to support the economy” indicated that action was coming and the Fed has just delivered a 50bp rate cut. The decision followed a call between the G7 Finance Ministers and central bank heads that initially underwhelmed with little sign that coordinated action was going to be forthcoming.
The brief accompanying statement acknowledges that while economic fundamentals “remain strong… the coronavirus poses evolving risks to economic activity”. The FOMC is “closely monitoring developments and their implications for the economic outlook and will use its tools and act as appropriate to support the economy”, acccording to an ING research paper.
“We doubt today’s policy action will trigger a meaningful boost to aggregate demand, but implementing rate cuts may help to mitigate some potential strains in the financial system and give a lift to sentiment.”
Even so, while stocks jumped immediately on the news, skepticism about monetary policy as the answer to a health scare quickly led investors to flee to safety. The yield on the 10-year Treasury bond fell below 1% for the first time. The Dow climbed as much as 381 points higher and then dropped by nearly 1,000 points before settling in 785 points down for the day — a 2.9% decline to 25,917.
The Coronavirus outbreak started out as a supply chain shock for the US due to disrupted supply chains as factories closed in China and other parts of Asia. However, over the past couple of weeks it escalated into a financial shock as markets recognised Covid-19 was going to have a much broader impact on the global economy.
The concern now is that the fear factor surrounding Covid-19 will change corporate and consumer behaviour and lead to a demand shock as well. This is most likely through the service sector of the economy with travel, hotel accommodation, restaurants and leisure-related sectors looking vulnerable. Add in the prospect of significantly weaker export performance and a negative second quarter GDP print is looking a distinct possibility.
Given the uncertain outlook for the path of the virus most governments are advising the situation is likely to deteriorate before hopefully easing over the summer.
With economic activity likely to be significantly impacted and inflation set to fall pretty sharply – energy prices are set to plunge on oil while core inflation will likely edge lower as weaker demand offsets the supply shock – we are pencilling in two further 25bp rates cuts for 2Q giving a total of 100bp of easing.
With courtesy of ING Bank N.V. The article first appeared here.