On the Minds of Investors
04/03/2020
Dr.David Kelly
Monetary Medicine of Limited Effectiveness
The Federal Reserve (Fed) cut the federal funds rate by 0.5% on Tuesday, in their first inter-meeting rate cut since 2008. In doing so, they cited the “evolving risks to economic activity” posed by the coronavirus. In an emergency press conference, Fed Chairman Jerome Powell said that the Fed took this action as it saw that the coronavirus was having a material impact on the economic outlook. Although this was clearly an attempt to bolster business confidence, it should be of limited effectiveness in dealing with problems being caused by the outbreak.
While a Fed rate cut had been priced into futures’ markets last week, the timing was something of a surprise, coming two weeks ahead of the Fed’s next meeting on March 17th and 18th. In taking this action, (on a unanimous vote of the committee), the Fed has once again displayed a dovish tilt and it is probable that the Fed will follow up this action with further rate cuts at their March meeting or later in the year if economic conditions deteriorate further. It should be noted, however, that the Fed has limited ammunition, with the federal funds rate now standing in a range of 1.00%-1.25%.
This rate cut may have limited effectiveness in combatting the dampening effects of the virus for two reasons. First, unlike many previous bouts of economic weakness, the problems caused by the virus and “social distancing” should be more significant for service sectors such as travel and leisure activities rather than the traditional cyclical sectors such as home-building and capital spending. These service sector activities, unlike the cyclical sectors, should not be sensitive to interest costs. In addition, many years of very low interest rates suggest that there is very little economic activity that is being held in check by financing costs anyway.
However, lower short-term interest rates, particularly if they feed through to lower long-term rates, should be able to provide a measure of support to the stock market by making both bonds and cash unattractive and this could ultimately limit a negative wealth effect from falling equity prices. In addition, while the coronavirus is clearly a global problem, the Fed is the only major central bank with scope to cut rates. If they continue to do so, they may succeed in weakening the dollar relative to other currencies which could provide a further limited economic boost.
Even with this Fed action, there will likely be growing calls for fiscal action, particularly to provide direct support to businesses that may increasingly suffer from the public response to virus fears. Such support in the United States could take the form of small business loans or, perhaps, some incentive to maintain employment among the hardest-hit sectors.
While we do not know how deep any economic downturn from the coronavirus could be, we do know that it is unlikely to last multiple years. This being the case, valuations of long-term assets are important and the Fed’s action today further enhances the valuation of global stocks relative to bonds or cash.
For investors, this remains a time to check that their portfolios are allocated in line with their long-term objectives and risk tolerance. It is also a time to double-check that, at a micro level, the companies they are invested in are ones that can weather an economic downturn and thrive in a rebound.
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