The Fed has already slashed interest rates and flooded the markets with liquidity, but it will have to go further in the coming weeks, with a return to near-zero interest rates and a resumption of large-scale quantitative easing now likely.
- The Fed has already slashed interest rates and flooded the markets with liquidity, but it will have to go further in the coming weeks, with a return to near-zero interest rates and a resumption of large-scale quantitative easing now likely.
- Following the 50bp emergency inter-meeting rate cut last week, we expect the Fed to lower rates by an additional 50bp at next week’s scheduled FOMC meeting, with a final 50bp reduction at the late-April meeting taking the fed funds rate back to its crisis-era level of between 0.0% and 0.25%. Moreover, given the extent of the turmoil in both equity and bond markets in recent days, it’s no longer out of the question that the Fed could surprise markets with a shock and awe-style 100bp rate cut next week. Fed officials have previously suggested that, when rates are already close to the zero bound, it makes more sense to act quickly rather than to keep ammunition in reserve.
- With signs of illiquidity emerging in the Treasury market, yesterday the NY Fed announced a dramatic expansion of its repo auctions which, if markets take the Fed up on its offerings, will see the Fed’s balance sheet increase to a record high in one fell swoop. The Fed is offering a total of $1,500bn in three additional $500bn term repo auctions to be conducted over two days. That could increase overall reserve bank credit to $5.6trn, from the current $4.1trn. For comparison, as recently as last week, the total value of repos outstanding was less that $200bn. Moreover, the expansion of the balance sheet is bigger than the increase resulting from all the different emergency loan programs during the financial crisis and it is roughly the same size as QE1, introduced in early 2009.
- In addition, the monthly $60bn of Treasury purchases the Fed was already conducting will now be spread across all maturities rather than focusing only on short-term Treasury bills – and the proposal to wind down those purchases in another month or two has been abandoned. The Fed originally opted to buy only T-bills in an effort to distinguish its balance sheet management operations from full-blown QE. But the former has now morphed into the latter, even if part of the reason for the switch is that the illiquidity at the short end of the Treasury curve occurred because the Fed had been absorbing all the supply.
- The next step would be to expand the pace of monthly purchases, which we think the Fed will probably do at next week’s FOMC meeting. Unfortunately, with yields already below 1% across most of the curve, quantitative easing is going to do little to drive longer-dated yields even lower, meaning that any boost to economic activity would be a lot more modest than we saw during earlier QE programs. At this stage, there would be little point in introducing a yield control target either.
- Quantitative easing would be more effective if the Fed bought riskier assets, such as corporate bonds or even equities, but the Federal Reserve Act currently prevents it from doing so. It’s possible that Congress would consent to amend the law, but there are no plans to do so yet. Boston Fed President Eric Rosengren recently suggested that if Congress made those changes, the Treasury should indemnify the Fed against any losses on holdings of those riskier assets.
- Finally, while the Fed has taken its first steps in providing additional liquidity to the financial system, we think it will also need to make funding available to the non-financial corporate sector and possibly households too. During the financial crisis, the Fed operated a facility called the Term Asset-Backed Loan Facility (TALF), which used $20bn in capital put up by the Treasury from the TARP program to buy $200bn of asset-backed securities composed of various consumer credit categories and loans guaranteed by the Small Business Administration (SBA). President Donald Trump has already announced plans to double SBA loans to $50bn, but there would be scope to leverage up the size of that program if the Fed was willing to expand its balance sheet to supply credit to non-financial corporates with the SBA guaranteeing any losses on those loans.
Paul Ashworth, Chief US Economist, +1 416 874 0520, firstname.lastname@example.org