Commenting on the Fed’s emergency rate cut, which while expected was extremely unusual and only the first one since the financial crisis, Obama’s chief economic advisor Larry Summers laid out the problem Powell is facing, especially now that the Fed appears to have lost much of its remaining credibility:
Fed Risks ‘Scaring People’ With Rate Cut. My interview today on the Fed’s emergency rate-cut on @BloombergTV.
When you have limited ammunition you have to conserve it. The Fed has limited ammunition with interest rates so low. Interest rates don’t cure the #coronovarius and interest rates don’t repair supply chains.
While Larry Summer’s opinion has been repeatedly discredited over the years, he does bring up a valid point: why is the Fed wasting half of all of its ammo just to delay what is now an inevitable crash, and why scramble with an “intermeeting” cut when it could have jawboned for the next two weeks and waited until the regular March 18 FOMC meeting. If anything, it would at least eliminate the sense of Fed panic from the equation.
Instead, as it stands, “it smells like panic” as more than one Wall Street veteran put it.
Worse, as BMO’s Ian Lyngen puts it, what happened after the Fed’s emergency 50bps rate cut, the biggest since Jerome Kerviel blew up SocGen, “the situation didn’t play out exactly as Powell might have envisioned.“
So just how bad is it? Well, as plunging stocks demonstrate, the Fed is this close from losing all credibility…. and since the market has been held up for the past 11 years on nothing but Fed faith – and trillions in Fed liquidity – this could be a very, very big problem.
The Fed’s emergency 50 bp rate cut brought 10-year yields to fresh record lows and a 0-handle was realized. To a
great extent, we’ll argue the situation didn’t play out exactly as Powell might have envisioned. It’s doubtful that
when JP left home this morning he thought ‘50 bp will really crush the stock market.’ So it goes.
The precipitous slide in equities was the driver behind the ease to begin with – as the spike in equity vol translated to tighter financial conditions via this now well-traveled path. This is where it becomes problematic; while stocks initially rallied on the ‘good news’ of rate cuts, the optimism quickly faded as the intermeeting nature of the move raised more questions than it answered. On one hand, the Fed is willing to be proactive but on the other, how much more will rates ultimately need to be cut?
If the FOMC wanted this exercise to be a ‘one-and-done’ event, that message wasn’t correctly communicated to the futures market which presently has roughly 60% odds of another move in two short weeks priced in. Admittedly, the 100% probability for the next cut being a quarter-point is worth a nod. Given the way in which risk markets are responding to today’s half-point, it’s challenging to imagine a 25 bp move would be met by the warm risk-on embrace to which monetary policymakers have become accustomed. We’ll stop shy of labeling it a ‘face-in-hand’ day for the Fed; if nothing else the question of whether or not just 50 bp would suffice has been answered… hint: it was ‘no’.
The biggest risk was always that by acting too proactively and aggressively Powell would signal that the situation is worse than initially feared. Check.
With 10-year yields on a slippery slope to 75 bp (there, we said it) and 2s conceivably poised to touch 50 bp, it’s somewhat concerning that the 2s/10s curve hasn’t steepened out any more – 34.5 bp remains the line in the sand. The rationale for the reluctance to steepen is sound; lower rates cannot cure the coronavirus and are unlikely to fully offset the hit to consumption, confidence, and inflation. As a result, the accommodation only creates a muted inflationary impulse.
It gets worse:
In two short weeks the Committee will be faced with a very difficult decision of either underwhelming investors’ expectations or quickly utilizing the limited rate-cutting potential afforded by the low outright yield environment.
Once the effective lower-bound is established, expanding the balance sheet will become topical and if risk sentiment isn’t restored by dropping rates, the next tool in the policy box will be expanding the balance sheet. As the Fed determines the next installment of accommodation, the signaling power for responding to Tuesday’s stock selloff will undoubtedly be a consideration; after all, the takeaway from the first 50 bp was that another will quickly follow and there is information held at the Fed which investors can only utilize by following the lead of central bankers.
Said differently, if Powell’s nervous, perhaps we all should be. At least that was the sentiment behind the flight-to-quality that brought 10-year yields to just 89 bp intraday.