Date: March 01, 2020
From: Bill Nelson
Subject: Don’t Keep Your Powder Dry
Those of you who haven’t understandably tagged my emails for “straight to spam” may have read my observation this past Saturday (see here) that the FOMC’s forward guidance, and the structure of the Committee that gave rise to it, would result in the Committee first staying on the sidelines as markets collapse and then executing a big cut to generate a positive market reaction (and boost confidence). I had noted the tendency for the market to respond poorly to negative shocks when the Fed says it is on the sidelines back in October (see “The Fed is on the sidelines and it could be bumpy ahead”)
Now that we’ve observed the first part of that dynamic, and with Chair Powell’s comforting statement Friday afternoon that Fed will “act as appropriate,” the question is “what will the Fed’s big cut look like?” Here’s my call (and by “call” I mean both what I think they will do and what I think they should do).
There will be a coordinated easing across the major central banks and, possibly, the People’s Bank of China and the HKMA. The global nature of the problem calls for a global response, a coordinated easing avoids the risk of competitive devaluations, and the coordinated actions during the financial crisis were considered especially helpful. In the FOMC conference call (transcript here) in advance of the coordinated interest rate cut on October 8, 2008, then Chairman Bernanke stated
“I think it would be extraordinarily helpful to confidence to show that the world central banks are working closely together, have a similar view of global economic conditions, and are willing to take strong actions to address those conditions.”
The cut will be substantial, at least 50 and possibly 75 basis points. When the Committee eases policy it judges the effectiveness by the market reaction. (By contrast, when the Committee tightens policy, it wants to avoid surprises). The only way to get a positive market reaction is to deliver more than expected. I’ve copied below a few indicative discussions from past FOMC transcripts.
The easing will include forward guidance designed to build confidence “we are going to do whatever it takes” rather than reduce confidence “the outlook is so grim we expect to keep rates low for a long time” or worse “this cut should be sufficient and it would take a further material change in the outlook for us to do more.” Given the ascendancy of the view in the Committee (in light of last week’s developments) that the biggest risk is for inflation expectations to start moving down, I wouldn’t be surprised by guidance like “We will not tighten policy before the 12-month PCE inflation rate is above 2 (or 2.25) percent for 6 months.”
The cut will take place this Wednesday morning at 7 or 8 AM. The coordinated international actions on December 12, 2007 (time unknown), October 8, 2008 (7:00 AM), and November 30, 2011 (8:00 AM) were all on Wednesdays. The Committee no doubt had a conference call at least once this past week (although perhaps just for a staff briefing) and will meet again this weekend, probably tomorrow. Chair Powell will provide a readout of his discussions with other central bankers. An announcement Wednesday will provide time for all the other central banks to take whatever internal steps are necessary. It will also allow time to see if the Chair’s Friday announcement by itself will calm the markets (seems unlikely to me). If markets are calm Monday and Tuesday, I’m not sure what will happen.
A note on the “keep your powder dry” fallacy. There is an intuitive appeal to the idea that a central bank, when getting near the zero lower bound, should hold back a bit so it can cut more later if needed; that it should keep its powder dry. This is exactly wrong and is widely understood within the Fed to be exactly wrong. The worst outcome is that the central bank hits the zero lower bound and a deteriorating economy results in declining inflation. At that point, because the amount of economic stimulus is determined by the real interest rates, not the nominal interest rate (the real interest rate is the nominal rate minus expected inflation), monetary policy gets tighter and tighter as inflation falls, leading to a deflationary spiral. To reduce the likelihood of that outcome, once the zero lower bound gets near, the central bank should move to zero faster, not slower.
As always, comments, discussion, and forwarding welcome. Don’t miss the transcript snippets below!
Some past FOMC discussions about delivering a positive surprise:
Transcript 2002 November 6
Pres. McDonough: “First of all, the immediate market reaction to 25 basis points slanted toward weakness would be that the Committee is composed of a bunch of wimps….”
MR. PARRY. Mr. Chairman, to me it makes a lot of sense to go with the 50 basis point cut, one that is large enough to have a noticeable effect.
MR. BIES. Mr. Chairman, I support the recommendation to go down 50 basis points on the funds rate. I think we need to show that we are ahead at this point in the economy.
MR. KOHN. Recent data are sufficiently worrisome and the most likely forecast is sufficiently tepid to justify 50 basis points. And I do think it would feed through to long-term interest rates. Looking at Vincent’s chart of the upward-sloping expected federal funds rates, if the markets see us moving a little more aggressively, I think that could flatten that chart out a little, and the effect would feed through to longer-term interest rates.
Transcript January 21, 2008 (intermeeting) (worth reading the transcript – lots of talk of uncertainty and the nature of recessions.)
Bernanke, p. 9 I think we have to take a meaningful action—something that will have an important effect. Therefore, I am proposing a cut of 75 basis points… So that is my case. I think we really have no choice but to try to get ahead of this.
Yellen, p. 12: At this point, they are expecting at our next meeting more than 50 percent odds of a 75 basis point cut. An intermeeting move will be a surprise, but I think it will show that we get it and we recognize we have been behind the curve.
President Fisher, p. 17 There are some pros to moving now, and there are some cons. Clearly, one of the pros is that we would have the element of surprise.
Lockhart p. 16: I think the psychology here is bordering on, shall we say, a spiral quality. A preemptive move like this—preemptive on two dimensions, the rate dimension and the timing dimension—has a shot at changing the overall psychology of the moment…
Kohn p. 22 But part of what is driving this fear and eroding confidence is the concern about recession. I think lowering interest rates, doing it promptly, and doing it emphatically with 75 basis points, as well as acting through the usual channels, will help ameliorate that fear.
Transcript March 17-18 2009
Gov. Warsh. P. 211, In terms of the size of these various elements, I think the only thing worse than buying Treasuries is to buy them in such a tepid way that we don’t have any effect. I think if we’re in, we’re in. We’re crossing the Rubicon.
CHAIRMAN BERNANKE. Thank you. Let’s try to put this all together. Most importantly, I think there’s a pretty strong consensus for the combined package, the total of $1.15 trillion. I heard the point about doing even more in Treasuries. I guess I think that just crossing the Rubicon will have a significant announcement effect, because it will signal our willingness to do more if necessary in the future.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.