Fed springs a surprise; cuts rates by 50 basis points

On March 03, 2020, the Federal Reserve announced a pre-emptive rate cut of 50 basis points in one stroke.

Mar 04, 2020 08:03 IST India Infoline News Service

The signals that the Fed would cut rates to combat the impact of Coronavirus were always there. The CME Fedwatch has been hinting at two rate cuts by the end of April 2020. In fact, the Fedwatch had already assigned a 100% probability to a 25 bps rate cut in the March Fed meet. What actually transpired took most markets across the globe by surprise. On March 03, 2020, the Federal Reserve announced a pre-emptive rate cut of 50 basis points in one stroke. Effectively, the Fed rate range has now fallen from 1.50-1.75% to the new range of 1.00-1.25%. Even the Fed has been quite categorical about the need for rate action to combat the slowdown caused by the Chinese pandemic. This takes the total rate cut to 125 bps in the last one year as shown in the chart below.

Fed rate cut
Chart Source: US Federal Reserve
 
As the above chart depicts, the US Fed Rates were kept at 0-0.25% levels till the end of 2015 when the Fed hiked rates by 25 bps after a gap of nearly 10 years. However, by late 2018, the Fed rates had already touched a level of 2.5%. Over the last one year, there has been substantial pressure from the markets and from the US President leading to the Fed cutting rate by 125 basis points. Out of the 125 bps cut, 50 bps was done outside the Fed Policy meet on 03 March and represents an aggressive stance by the US Fed and a willingness to forsake price stability for the sake of growth.
 
Indications of a rate cut were already there
 
To be fair, the rate cut by the Fed cannot be classified as a surprise, although the speed and the extent of the cut were. There were 3 clear indications that the US Fed would cut rates, sooner rather than later. Firstly, the Fed Chief, Jerome Powell, had already indicated to the markets that the Fed was keeping all options open to combat the slowdown caused by the Chinese virus. Secondly, the US had been displaying occasional signals of deflation with the 5-year yields going below the 3-year yields leading to an inverted yield curve. This needed an urgent monetary stimulus. Lastly, the best indication of a quick rate cut was given by the US 10-year benchmark yield curve which had seen the yields fall by nearly 50 basis points in the last one month.

US 10-yrs yields
Chart Source: Investing.com
 
Will the US Fed rate cut really make a difference to growth?
 
There have been two arguments against the Fed cutting rates. The first argument is that the focus of the central bank should be on price stability and not on equity markets. The second argument is that even if the Fed cuts rates, growth and consumption were unlikely to pick up. Actually, both these arguments are technically correct but practically flawed.
 
Firstly, it is true that the central bank must not worry about the vagaries of the equity markets. In that case, the Fed need not have intervened in 2008 when markets were crashing. Like in 2008, the falling markets today are a lead indicator of a larger structural issue facing the US economy. The last thing any economy wants is businesses to be stifled by high yields at a time when growth has been largely elusive. From that perspective, rate cuts do make sense.
 
Secondly, Rabobank had raised the issue of growth in an incisive report which stated that rate cuts would not stimulate growth. But that is not the purpose anyways. The purpose here is to instil confidence in the markets that the Fed and the government are willing to stand behind corporate America as they fight to ward off a slowdown. In terms of business confidence and consumer confidence; this rate cut can make a world of a difference.
 
Will the RBI follow suit? Read my lips says the Governor
 
Interestingly the RBI governor, Shaktikanta Das, had affirmed on March 02, 2020 that the central bank would be willing to provide support to the economy and financial markets in all possible ways. Interestingly, bond yields in India have also fallen from 6.80% in late December to 6.34% in early March. GDP growth has shrunk to 4.7% in the third quarter and full year GDP growth could stay below 5%. After cutting rates by 135 bps between Feb-19 and Oct-19, the RBI has maintained status quo. With inflation expected to come down, the RBI may just have to leeway to cut repo rates. One only hopes that the decision by the RBI does not get too delayed; as was the case during the 2008 Lehman crisis. That will be the key!

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