The three main reasons behind the Federal Reserve’s interest rate cuts on Tuesday help explain why the central bank is likely to lower rates again.
The Fed hoped to boost public confidence, prevent financial conditions from worsening and cushion the U.S. economy against a global growth downturn.
While the rate cut may help on each of those fronts, the outlook could grow darker in the weeks ahead as the number of U.S. coronavirus cases rises.
The rate cut Tuesday came between the Fed’s regularly scheduled policy meetings, illustrating urgency to get ahead of an unfolding shock, even if the underlying nature of the threat isn’t economic.
Since 1998, the Fed has cut interest rates six other times between regularly scheduled meetings. Following each of those moves, the Fed has lowered rates again at its next policy meeting.
“For us, what really matters of course is not the epidemiology, but the risk to the economy,” said Fed Chairman Jerome Powell on Tuesday. “So we saw a risk to the outlook for the economy and chose to act.”
Any good economic data released in coming weeks can be easily dismissed because they will show how the economy fared prior to the spread of the virus. And more bad news seems likely.
Confidence could falter as health authorities test more widely for the infection, revealing how far it has spread and possibly prompting school closures and remote work arrangements.
“The effects are at a very early stage,” said Mr. Powell, referring to increasingly negative sentiment from travel and hospitality businesses. “We expect that will continue. It will probably grow.”
The same dynamic could weigh on financial markets. Measures to contain and mitigate the damage could force companies to lower their earnings forecasts and weigh on stock and corporate-bond markets. The Fed acted Tuesday rather than wait until its March 17-18 meeting to prevent a deeper pullback in credit availability that can occur when lenders reassess borrowers’ creditworthiness.
Mr. Powell said the Fed was prepared for a possible increase in corporate defaults or business failures. “We don’t see any of that happening yet. Of course, we are thinking about what we can do, should those things happen,” he said.
Finally, the U.S. economy faces disrupted supply chains and weaker global economic activity. This downturn could deepen if policy makers abroad aren’t able or willing to spur growth. Interest rates are already low and many central banks don’t have the wherewithal to reduce them much further.
Countries already experiencing low rates of growth—such as Italy, Japan and Germany—are very likely to sink into recession in the coming months. “We need to be mindful that the impact from the outbreak could be big,” Bank of Japan Governor Haruhiko Kuroda said Wednesday.
Other central banks with interest rates above zero cut them this week. The Bank of Canada reduced its policy rate by half a percentage point, and the Reserve Bank of Australia reduced its policy rate by one-quarter of a percentage point to a record low of 0.5%.
The Fed’s cut took its benchmark rate to a range between 1% and 1.25%, leaving it more room than most other developed-economy central banks to cut further. U.S. rate cuts also make it easier for central banks in emerging markets to lower their borrowing costs without triggering capital flight.
U.S. bond markets may be showing greater signs of hazard ahead. The 10-year Treasury yield fell to new lows on Tuesday and Wednesday. While declines in bond yields in recent weeks have reflected lower inflation expectations and investors seeking havens, most of the most recent drop reflects lower growth expectations, said Roberto Perli, an analyst at research firm Cornerstone Macro.
Over more than 6,000 trading days since 1997, growth expectations reflected in the benchmark 10-year Treasury have fallen by a larger magnitude than they did on Tuesday only 25 times, and most of those were during or before recessions hit, he said.
Lower borrowing costs aren’t likely to be effective without broader confidence-building efforts by federal and local authorities to demonstrate they have put in place measures to diagnose and slow the spread of the new coronavirus.
Stock markets tumbled after Tuesday’s Fed decision but rallied on Wednesday, illustrating how investors are still reconciling the challenges facing corporate profits and economic activity in the months ahead.
Tuesday’s rate cut shouldn’t be judged by immediate market reactions, said Jim Vogel, a rate strategist at FHN Financial in Memphis, Tenn.
“It was not a ‘rescue’ mission that demands an immediate letter grade from bond or stock traders who are still dealing with intensely volatile prices,” he said. “It was a first step, designed to keep the central bank in line with [the disease’s] spread over the last two weeks.”
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