As a consequence of the Covid-19 pandemic and the potential catastrophic impact on the global economy, the Fed slashed interest rate to zero in March after four years of effort to increase its benchmark rate. In addition, it has also increased drastically the size of its balance in order to prevent the whole market from collapsing; the Fed’s balance sheet is now expecting to grow to USD 8/9 trillion by the end of the year, twice more than the high reached in October 2014. Even though there is no question that the whole economy was healthier this time than prior to the Great Financial Crisis and that the Fed’s interventions and liquidity injections were timely and mandatory to save the whole market, we believe that the rate cuts were unnecessary.
A slowing economy pre-virus
As we know, the US economy peaked in the last quarter of 2018 and was already considerably slowing down in 2019 due to the high uncertainty in the market (Brexit, followed by the China-US trade war). Figure 1 (left frame) shows the global and US manufacturing PMI overlaid with the US 10Y yield. After the global economy peaked in Q4 2017, the outperformance of the US relative to the rest of the World in 2018 led to a rising USD and a rising 10Y yield, but eventually the slowdown of the US economic growth brought the long-end of the Treasury curve to the downside.
In addition, the sharp sell-off in equities in Q4 2018 (nearly 20 percent from peak to trough) reversed the Fed’s policy guidance with the famous ‘Powell pivot’ from ‘a long way from neutral’ in October 2018 to ‘appropriate stance in January 2019. Policymakers even cut rate three times in the second half of 2019 in order to stimulate demand after the 2Y10Y yield curve inverted in August.
Source: Eikon Reuters, Bloomberg
Hence, the reversal in global central banks’ policy (from global tightening to global easing) combined with the significant increase in global liquidity led to a sharp recovery in stocks, with the SP500 recording one of its best year in the past 30 years (figure 2, right frame). However, the 2020 events generated a global panic and equities sold off aggressively in February/ March amid concerns of the global supply shock will soon spill over demand. Did the Fed increase volatility at first by just cutting interest rates to zero? Even though we understand that policymakers globally wanted to quickly reassure markets by hinting participants that it will not let the whole market fail, there has been very few debates on whether rate cuts are useful in a shutdown economy. In theory, rate cuts should decrease the incentives to save and increase demand for credit and the incentives to consume. We think that the massive liquidity injections would have been enough this time to halt the global panic and that policymakers should have save the little room left in the benchmark rate for later (i.e. when the economy reopens). In addition, we believe that the aggressive rate cuts may have increased price volatility in March; figure 2 (right frame) shows that stocks tend to sell rapidly in when Fed cut rates aggressively.
Source: Eikon Reuters
US shadow rate to hit -5 percent in 2020
Even though some economists have been speculating that the Fed will adopt a negative interest rate policy (NIRP) in the coming months as a response of the Covid-19 crisis, we are not convinced of that and we think that policymakers will first wait and see if the massive liquidity injections will be enough to stimulate the economy. Figure 3 shows the historical path of the Fed Funds rate since 1960, including the ‘shadow rate’ based on Wu-Xia calculations (2015),a tool that researchers have proposed in recent years to estimate how low would the benchmark rate be had the the Fed not used unconventional monetary policy.
This time, the shadow rate is expected to fall down to -5% by the end of the year, 2 percent lower than the -3 percent low reached in the third quarter of 2014 (due to QE3), which should in theory represents a massive stimulus for the economy.
Source: Eikon Reuters, Wu-Xia (2015)
Key economic measures such as r-star have become less relevant in the past cycle
Unlike most of the central banks, the Fed follows a triple mandate when conducting its monetary policy, which is to achieve the following goals: maximum employment, stable prices and moderate long-term interest rates. In addition, policymakers have tried to estimate the dynamics of the (unobservable) neutral rate of interest, r-star, which can be defined as the interest rate that supports the economy at maximum employment while keeping stable prices. Figure 4 (left frame) shows the relationship between r* (estimated by Holston et al. (2017)) and the implied Fed Funds rate (including the shadow rate). Policymakers’ have usually immediately been reacting by lowering the FFR when the r-star was starting to decrease due to an economic shock / recession.
We do not have the recent Q1 updates for r-star, but it is fair to say that it will decrease drastically, which would support the argument of a lower FFR. However, the Fed should just have increased the size of its balance sheet this time (which would have lowered the shadow rate) while keeping extra room for FFR intervention in the coming months when economies reopen.
In addition, we can also see that the relationship between the implied FFR and the US saving rate has broken down in the past cycle (figure 4, right frame). Before 2008, lower FFR was usually leading to a lower saving rate in the following 2 to 3 years (lower rates decrease the incentive to save and should increase the incentive to consume). However, since 2009, while interest rates reached the lower bound and even decreased if we look at the shadow rate, the saving rate has increased. The saving rate could actually go even higher given the uncertainty that households will face post lockdown.
Source : EIkon Reuters, Holston et al. (2017), Wu-Xia (2015)
In short, more rates cuts are useless in a shutdown economy; policymakers should leave some room for later in case of a ‘Wsss – shape’ recovery.