This past Sunday, the U.S. Federal Reserve (Fed) fired a last desperate salvo in an attempt to stabilize financial conditions, the second emergency inter-meeting cut in two weeks. In addition to cutting the federal funds rate range to 0-0.25%, the Fed also re-launched quantitative easing and loosened lending conditions in an attempt to keep credit flowing to the real economy. Just two days later, the Fed announced a special credit facility, supported by Treasury, to purchase unsecured corporate paper in an effort to shore up liquidity for struggling businesses. But despite the unprecedented amount of monetary policy stimulus, volatility continued in financial markets: Monday’s market close had the S&P 500 recording its third consecutive daily move of greater than 9%, a feat last seen in October 1929; the rest of the week will likely feel similar.
Many investors are, therefore, wondering: can the Fed do more? Unfortunately, moving forward, the Fed’s options for additional stimulus are limited, and each comes with a set of complications that challenge their viability:
- An overhaul of regulatory conditions: current liquidity requirements have locked up cash and a ban on proprietary trading prevents banks from supporting credit markets; adjustments to these rules could ease conditions. However, regulatory reform is a slow process and, therefore, unlikely in the near-term.
- A broadened policy remit: negative interest rates or an expanded asset purchase program by which the Fed can purchase corporate bonds. However, Fed officials have been openly skeptical of these unorthodox policies, particularly negative rates, and such changes would likely require Congressional approval.
- A targeted lending program: additional support for virus-impacted small and medium size firms. Because the Fed is unable to assume credit risk, future lending programs will require additional support from and coordination with U.S. Treasury.
Ultimately, investors must realize that easier monetary policy, regardless of its current or future form, makes income harder to come by. It should, therefore, force money into risk assets, supporting public equity market valuations and encouraging investors, where and when suitable, to reach for income in higher-yielding, but riskier, private markets. Most high quality bonds will be relegated to a role of insurance.
Perhaps more importantly, though, is the realization that the effectiveness of monetary policy is likely approaching its limits, particularly given the complex politics underlying the need for future inter-agency coordination. It is also important to remember that monetary policy can only do so much in addressing fears related to a pandemic: the reasons for, and the problems because of, things like “social distancing” cannot be fixed by lower interest rates. For this reason, robust fiscal stimulus is urgently needed to first stabilize both financial markets and the economy, and second, to promote recovery.