Preventative move? US Fed Reserve abruptly cuts interest rates

Concerned about slowing economic activity, the U.S. Federal Reserve made a surprise move Sunday to cut rates and inject $700B into bond markets. 

AP Photo/Jacquelyn Martin
Federal Reserve Chair Jerome Powell, seen here at a news conference on March 3, 2020, has recently noted that the coronavirus “poses evolving risks to economic activity." On Sunday, in a surprise move, the Federal Reserve cut its benchmark interest rate.

The Federal Reserve took emergency action Sunday to help the economy withstand the coronavirus by slashing its benchmark interest rate to near zero and saying it would buy $700 billion in Treasury and mortgage bonds.

The Fed’s surprise announcement signaled its concern that the viral outbreak will depress economic growth in the coming months and that it’s prepared to do whatever it can counter the risks. It said it would keep its key rate at a range between zero and 0.25% until it feels confident that the economy can survive what’s become a sudden near-shutdown of economic activity in the United States.

The central bank will buy $500 billion of Treasury securities and $200 billion of mortgage-backed securities – an effort to smooth over market disruptions that have made it hard for banks and large investors to sell Treasuries as well as to keep longer-term rates borrowing rates down. The disruptions in the Treasury market sent the yield on the 10-year Treasury rising last week, an unusual move that threatens to push borrowing costs for mortgages and credit cards higher.

All told, the Fed's massive response is intended to keep financial markets functioning and lending flowing to businesses and consumers. Otherwise, as revenue dries up for countless small businesses that have suddenly lost customers, those employers could be forced to lay off workers or even seek bankruptcy protection.

"This is a break-the-glass moment" for the Fed, said Mark Zandi, chief economist at Moody’s Analytics. "They are throwing everything they’ve got at this. My sense is they must be nervous about the credit system not functioning properly. They are trying to shore up confidence."

By aggressively slashing its benchmark short-term rate to near zero and pumping hundreds of billions of dollars into the financial system, the Fed’s moves Sunday recalled the emergency action it took at the height of the financial crisis. Starting in 2008, the Fed cut its key rate to near zero and kept it there for seven years. The central bank has now returned that rate – which influences many consumer and business loans – to its record-low level.

"The Fed needed to act now, late Sunday afternoon on the U.S. east coast, before the open of Asian markets in just a few hours," said Bankrate.com chief financial analyst, Greg McBride. "The Fed is dusting off the financial crisis playbook, returning to bond buying, coordinating with other global central banks to provide access to U.S. dollar liquidity, cutting interest rates to zero, and opening the Fed’s discount window to ensure the flow of credit through banks to consumers and businesses."

Some of the Fed's new steps are intended to free up money for banks to lend. As businesses across the country see their revenues dwindle as consumers stay home, they will seek short-term loans to maintain their payrolls. The Fed said it has dropped its normal requirement that banks hold cash equal to 10% of its customers' deposits, allowing banks to lend those funds. It also said banks can use additional cash buffers that were imposed after the 2008 financial crisis for lending.

"The Federal Reserve is prepared to use its full range of tools to support the flow of credit to households and businesses and thereby promote its maximum employment and price stability goals," the central bank said.

"It confirms that the Fed sees the economy going down ... very sharply" toward recession, Adam Posen, president of the Peterson Institute for International Economics, said.

The Fed also announced that it has cut interest rates on dollar loans in a joint action that it has taken with five central banks overseas. That is intended to ensure that foreign banks continue to have access to dollars that they lend to overseas companies.

All told, the Fed's actions amount to a recognition that the U.S. economy faces its most perilous juncture since the recession ended more than a decade ago.

Still, with the virus' spread causing a broad shutdown of economic activity in the U.S., the Fed faces a daunting task. Its tools – intended to ease borrowing rates, facilitate lending, and boost confidence – aren't ideally suited to offset a fear-driven halt in spending and traveling.

"We have to hope that the Fed getting out in front of events, not to mention other central banks, pushes the economy in the right direction," said Adam Posen, president of the Peterson Institute for International Economics. "The heavy lifting for stimulus and for preventing lasting economic damage has to be done on the fiscal side. That’s nature of this shock."

"It confirms that the Fed sees the economy going down ... very sharply" toward recession, Mr. Posen said.

Mr. Posen advocates fiscal steps such as providing sick leave and pay for quarantined workers and rolling over bank loans to small and medium sized businesses hit hard by the outbreak.

"This isn’t going to be the magic bullet that saves everything," said Timothy Duy, an economist at the University of Oregon who follows the Fed.

But it sends a signal to Congress that the economy needs emergency stimulus. Mr. Duy also predicted that the Fed will follow up with more moves, including possibly changing its inflation target to allow for more stimulus and providing more support for commercial paper – the short-term notes that companies issue to meet expenses.

"I don’t think they’re done yet," Mr. Duy said.

Mr. Duy said the asset purchases are an "effort to keep markets from freezing up."

Earlier, Treasury Secretary Steven Mnuchin said that both the central bank and the federal government have tools at their disposal to support the economy.

Mr. Mnuchin also said he did not think the economy is yet in recession. Most economists, however, believe a recession is already here, or will be soon. JPMorgan Chase predicts the economy will shrink 2% in the current quarter and 3% in the April-June quarter.

"I don't think so," Mr. Mnuchin said, when asked if the U.S. is in recession. "The real issue is what economic tools are we going to use to make sure we get through this."

On Saturday, President Donald Trump reiterated his frequent demand that the Fed "get on board and do what they should do," reflecting his argument that benchmark U.S. rates should be as low as they are in Europe and Japan, where they're now negative. Negative rates are generally seen as a sign of economic distress, and there's little evidence that they help stimulate growth. Fed officials have indicated that they're unlikely to cut rates below zero.

With the virus depressing travel, spending, and corporate investment and forcing the cancellation of sports leagues, business conferences, music performances, and Broadway shows, economists increasingly expect the economy to shrink for at least one or two quarters. A six-month contraction would meet an informal definition of a recession.

"You can take to the bank that we’re going to have negative growth in the second quarter," said Nathan Sheets, chief economist at PGIM Fixed Income.

"The expansion is under threat," said Philipp Carlsson-Szlezak, chief economist at the Boston Consulting Group. "There’s a very plausible risk this will amount to a recession."

Two weeks ago, in a surprise move, the Fed sought to offset the disease's drags on the economy by cutting its short-term rate by a half-percentage point – its first cut between policy meetings since the financial crisis. Its benchmark rate is now in a range of 1% to 1.25%. Some analysts have forecast that the Fed will reduce its rate by just one-half or three-quarters of a point on Wednesday, rather than by a full point.

But policymakers have largely accepted research that says once its benchmark rate approaches zero, it would produce a greater economic benefit to cut all the way to zero rather than just to a quarter- or half-point above. That's because it takes time for rate cuts to work their way through the economy. So if a recession threatens, quicker action is more effective.

Some of the attention Wednesday will likely be on what steps the Fed takes to further smooth the functioning of bond markets, a topic that can seem esoteric but that serves a fundamental role in the functioning of the economy. The rate on the 10-year Treasury influences a range of borrowing costs for businesses and consumers, including mortgage and credit card rates. If banks and investors can't seamlessly trade those securities, borrowing rates might rise throughout the economy.

"Even more important than the Fed's rate-cutting function is the market-calming function," said David Wilcox, a senior fellow at the Peterson Institute for International Economics and former head of research at the Fed.

The central bank took a huge step in that direction Thursday, when it said it would provide $1.5 trillion of short-term loans to banks. The central bank will provide the cash to interested banks in return for Treasuries. The loans will be repaid after one or three months.

That program is a response to signs that the bond market has been disrupted in recent days as many traders and banks have sought to unload large sums of Treasuries but haven't found enough willing buyers. That logjam reduced bond prices and raised their yields – the opposite of what typically happens when the stock market plunges.

The Fed also said last week that it would broaden its $60 billion monthly Treasury purchase program, launched last fall, from just short-term bills to all maturities. The Fed is already reinvesting $20 billion from its holdings of mortgage-backed securities into Treasuries of all durations, thereby bringing its total purchases to $80 billion.

Those purchases would help relieve banks of the Treasuries they want to sell. Some analysts expect the Fed to extend those purchases past their current end-date of the second quarter and even vastly increase the size.

On Wednesday, the Fed's policymakers will also update their forecasts for the economy and for interest rates. Economists at Pimco predict that the Fed's policymakers will collectively downgrade their estimate for growth this year from 2% to below 1.5%. That figure would be consistent with an economic contraction in the first half of the year, followed by a sharp rebound, Pimco said.

This story was reported by The Associated Press.

of stories this month > Get unlimited stories
You've read  of  free articles. Subscribe to continue.

Unlimited digital access $11/month.

Get unlimited Monitor journalism.