What's ahead for the Fed?

A perspective from E*TRADE Capital Management, LLC 06/11/20

The Federal Reserve committed to maintaining near-zero interest rates for the foreseeable future during its policy meeting on Wednesday, June 10. After slashing the federal funds target range to 0–0.25% in March, members of the Federal Open Market Committee (FOMC) unanimously supported keeping short-term rates at the current level through 2022.1 

In the three and a half months since it first acknowledged the risks posed by the coronavirus, the central bank has taken unprecedented steps—both in speed and scope—to help support the economy as the pandemic forced much of the country to stay home and many businesses to shutter their doors. While the Fed’s actions are ultimately targeted at high-level economic goals, they are important for investors because they directly affect financial markets and tend to influence market sentiment, asset prices, and how businesses and consumers behave.

Let’s take a fresh look at the tools the Fed has deployed since March, where it currently stands in its fight against the virus-induced downturn, and what it may have left up its sleeve. After all, the Fed’s full-force stimulus response to the current crisis may be one for the history books, and will play a leading role in how the economy and markets recover.

US fed funds target rate

FactSet Research Systems, June 10, 2020

A "full range of tools"

In recent history, the Federal Reserve has focused on two primary tools to achieve its monetary policy goals: adjusting interest rates and purchasing and selling government-backed securities, which are among the actions it took to prop up the economy in the 2008–2009 downturn. 

The FOMC, which is the policy-making arm of the Fed, issued two emergency rate cuts in March, slashing the federal funds rate by a total of 150 basis points at the outset of the crisis—the largest cuts since December 2008. Although the fed funds rate is an overnight lending rate used between banks, it’s used as a benchmark for other rates as well, which in turn affect how businesses and consumers decide to borrow and spend. So, by cutting the fed funds rate, the Fed lowered the cost of borrowing on credit cards, mortgages, auto loans, and home equity loans, and made money easier for businesses to borrow and invest.

The Fed also took immediate action to keep markets functioning and money flowing through the economy on a massive scale, deepening its tool chest to include: 

  • Expanding asset purchases: Also referred to as quantitative easing (QE), and a key tool employed in response to the 2008 financial crisis, albeit on a smaller scale. The Federal Reserve announced it would purchase an unlimited amount of US Treasuries and mortgage-backed securities, while also expanding its balance sheet to include investment grade and high-yield corporate bonds and ETFs—a first for the central bank.2
  • Lending to businesses: The Fed established two new programs allowing it to lend directly to highly rated corporations—another expansion of its 2008 toolkit. It also created the Main Street Lending Program to help small and mid-sized businesses secure loans.2
  • Lending to state and local governments: The Fed moved to prop up municipal bond markets by expanding its lending facilities to include state and local governments—an action it stopped short of doing in the 2008 financial crisis to avoid political entanglement.3 Its decision to purchase municipal debt in the current environment speaks not only to the hardships cities are facing in battling the pandemic, but also to the Fed’s “whatever it takes” approach.  

One way to look at it is that, in the past, one of the Fed's roles was to be the "lender of last resort," providing liquidity in emergencies. Now, some analysts argue it has become the "buyer of last resort," willing to prop up any market or asset by directly purchasing it. 

The current landscape

In addition to the monetary tools the Fed has deployed, Chairman Jerome Powell has used his high-profile position to bolster market sentiment—even making a rare appearance on 60 Minutes in May—by expressing his confidence in the ability of the American economy to rebound, while acknowledging the challenges it faces. While Powell has cautioned that it may take until 2021 for the economy to recover, he has said he does not see the US entering a depression and expressed optimism that the current downturn would be relatively short-lived.4

The Chairman has been unwavering in his commitment to deploying the full range of Fed weapons to combat the pandemic, his belief in the economy’s long-term resilience, and his firm stance on avoiding negative interest rates.

Looking ahead

In total, the Fed’s response could inject more than $6 trillion into the US economy5—a much larger stimulus package than what got the country through its last downturn. But while the Fed’s actions have helped ensure that markets can continue to function and businesses and households have access to credit in times of crisis, it cannot ultimately control the course of the virus. 

Here are some steps the Fed may take if the economy struggles to re-emerge from lockdown:

  • Expand lending: The Fed still has room to expand its lending facilities, including billions of dollars designated to the Treasury that could be used to support new or existing programs.2
  • Adopt yield curve control: The central bank could set a target for longer-term interest rates and conduct bond purchases aimed at lowering longer-term borrowing costs to stimulate economic activity.6
  • Provide more concrete guidance: As a recovery begins to take shape, the Fed could solidify guidance about its plans for rates and its quantitative easing program in the longer term.
  • Move interest rates below zero: While Powell has dismissed the possibility of negative interest rates on several occasions, it continues to be a hotly debated topic—even two Fed economists recently made a case for negative rates.7

The Fed sees structural fragility in the US economy and Powell has made it clear he will continue to rely on his full range of tools to keep the economy healthy as the labor market and inflation come under historic pressure. 

The FOMC is next scheduled to meet on July 29. Until then investors should remember to stay the course and keep investing decisions focused on individual timelines, long-term goals, and risk tolerance.

  1. CNBC, “Fed sees interest rates staying near zero through 2022, GDP bouncing to 5% next year,” 6/10/20, https://www.cnbc.com/2020/06/10/fed-meeting-decision-interest-rates.html
  2. The Brookings Institution, “What’s the Fed doing in response to the COVID-19 crisis? What more could it do?” 6/4/20, https://www.brookings.edu/research/fed-response-to-covid19/
  3. Politico, “Fed to buy municipal debt for first time, underscoring peril facing cities,” 4/9/20, https://www.politico.com/news/2020/04/09/fed-to-buy-municipal-debt-178222
  4. CNBC, “Powell says GDP could shrink more than 30%, but he doesn’t see another Depression,” 5/17/20, https://www.cnbc.com/2020/05/17/powell-says-jobless-rate-could-top-30percent-but-he-doesnt-see-another-depression.html
  5. CNBC, “Here is everything the Fed has done to save the economy,” 4/13/20, https://www.cnbc.com/2020/04/13/coronavirus-update-here-is-everything-the-fed-has-done-to-save-the-economy.html
  6. The Brookings Institution, “What is yield curve control?” 6/5/20, https://www.brookings.edu/blog/up-front/2020/06/05/what-is-yield-curve-control/
  7. CNN, “Fed economist pushes for unprecedented rate cut in the United States,” 6/8/20, https://www.cnn.com/2020/06/08/investing/negative-rates-federal-reserve/index.html

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