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Did the Fed have no other choice?

Timely insights from portfolio managers and industry experts on key financial, economic and political issues.

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      By Eric Stein, CFACo-Director of Global Income, Eaton Vance Management and Andrew Szczurowski, CFAPortfolio Manager, Global Income Group, Eaton Vance Management

      Boston - In response to Tuesday's emergency rate cut by the US Federal Reserve (Fed), Eric Stein and Andrew Szczurowski shared their reactions.

      Eric Stein: The Fed clearly wants to get ahead of things, so that's why the rate cut came today and why it's very likely the Fed could cut again at the next meeting on March 18. Today's cut was unanimous, which sends a strong signal that policymakers were very committed to doing this and will likely be looking to do more.

      I'm big believer that the yield curve matters. I suspect the Fed thought that the inversion at the front end of the yield curve — along with the stock market, inflation expectations, the US dollar, etc. — was telling it to cut, so it cut.

      Reasonable people can debate if the Fed overreacts to markets, but recall that as of a week or two ago, it was strongly pushing back against market expectations of a cut. In a situation like the virus, however, once the Fed decides it needs to react, there's no reason to wait because economic data will take some time to really mean anything. That's assuming the virus starts to really affect business activity in the US, which it hasn't for the most part yet, although it's likely data globally will be poor for at least the next quarter or two.

      Also, inflation expectations are already below target and falling significantly, so the Fed sees limited downside to cutting rates.

      Andrew Szczurowski: My take is a little different from Eric's. This is an extremely unique situation we are dealing with, so in 2020 the Fed can't look at the past playbook. I think the Fed knows deep down this isn't a situation that monetary policy can control. A rate cut of 50 basis points (bps) does little to stimulate demand from a virus-induced demand shock. The Fed could have cut 150 bps; I think that would still do nothing in the end. 

      The only real thing the Fed could have done at this time to calm investors' fears would be to develop a vaccine for the coronavirus, but alas, that's not its expertise. Cutting rates and expanding its balance sheet are two very blunt tools, so the Fed used one of those tools, which it decided was better than doing nothing. 

      But I would argue this is a time you want to keep that arrow in the quiver and save it for another day. While financial conditions may tighten a bit from here, they aren't tightening because interest rates are too high. They're tightening because the world is coming to grips with more travel bans, lockdowns and the widespread cancellation of large public events and conferences — these will have a dramatic negative impact on growth over the coming quarters. Unfortunately, a rate cut will do nothing to stimulate cruise demand and put those conferences back on the books.

      So Fed policymakers are sending a signal, but the markets will realize they are powerless. When markets don't react favorably to this rate cut, the Fed will think it needs to cut again, so it probably will. The only panacea for our current situation is time, but the Fed and the markets are not patient. We know the cancer that is growing in the US economy can't be treated with Advil, yet the Fed will keep upping the dose anyway.

      Eric Stein: While I agree that this is not a monetary problem per se, at the press conference Powell said it will be a multifaceted response led by health care professionals. In my view, the Fed viewed the cost of inaction as significantly higher than the cost of action and, therefore, it acted.  

      Andrew Szczurowski: The Fed cuts 50 bps in the morning and US equities fell 3% in the afternoon. I think that's the market's way of saying "This isn't your fight." If the Fed can warm the climate to burn out this virus, that would be nice.

      Let's keep in mind how much financial conditions loosened over 2019, with stocks up over 30% and credit spreads near post-recession tights. My real fear is that when the next recession comes, the Fed will be out of ammo because it spent all its bullets against a virus — a fight it was ill-equipped for. There are those who say the Fed has to attack slowdowns in the economy early and aggressively, but I believe this time is different.

      Eric Stein: It's probably no surprise that when assessing whether or not the Fed cut was a good thing, the market narrative will massively overreact to how stocks do today — and this will be from the same people who say that the Fed pays too much attention the stock market!

      Ultimately, I think the benefits of this cut outweigh the costs. If the Fed is going to act, it's better off acting sooner rather than later, as monetary policy typically works with long and variable lags. I think the game plan for the Fed is to be aggressive now and then let fiscal and health authorities globally do their part. In a perfect world, there would be a fiscal response before a monetary response, but the politics around fiscal policy are not conducive to that modus operandi.