How Far Will the Fed Go?

by David Stonehouse, AGF Management Ltd.

The blame game has already begun. Government institutions around the world are increasingly coming under fire for perceived inaction or delay in the face of the COVID-19 pandemic. Yet one institution may be above reproach: the U.S. Federal Reserve. Compared with other government bodies – and even other monetary policymakers – the world’s most important central bank has responded to the challenge of COVID-19 quickly and aggressively. It slashed rates to nearly zero in early March, and has since expanded its asset-purchase program and launched a multi-trillion-dollar package of emergency business loans. The question now is how much further it can or will go.

The good news is that the Fed still has plenty of dry powder. In some ways, the Great Recession provided a kind of dress rehearsal for the crisis of today, and some of the non-conventional measures the Fed and/or other central bankers took then are still in the monetary policy toolkit. Fed chair Jerome Powell also has the example of the Bank of Japan, which has been experimenting with unorthodox monetary policy through nearly three decades of slow-to-stagnant growth.

Following these templates, we see five general areas for further Fed action, but we don’t see all of them as equally probable. After all, just because the Fed can do something does not mean it will.

• Cut interest rates further
  Japan and Europe have demonstrated that the lower bound for policy rates is no longer zero. Yet we would be surprised to see the Fed follow suit. For one thing, the Japanese and European experiments have achieved questionable results, at best; some European policymakers have even begun to walk rates back toward zero. For another, in the free-market-oriented North American context, negative rates might be seen as antithetical to the proper functioning of an economy. And finally, in their public and private comments, Fed officials, while acknowledging that going negative is an option, have indicated that they’re extremely reluctant to employ it.
• Buy stock
  Again, Japan provides a template: its central bank established a stock-buying program almost a decade ago as a way to inject liquidity. As noted above, the Fed has already moved to expand its asset-buying program to include municipal and corporate bonds, and even a bit of high yield, so equity purchases could be next on the list. However, we think this is improbable, at least in the short term, in large part because such a move would require congressional approval. Furthermore, despite its transparent desire to provide support during this unprecedented challenge, the Fed has also insinuated that it intends to avoid crossing certain moral hazard lines as much as it can.
• Introduce yield curve controls
  In 2016, the Bank of Japan enhanced its quantitative easing (QE) program by setting target rates for both the short and the long end of the yield curve – a way to effectively maintain low long-term rates when short-term rates were already at or below zero. If he’s contemplating a similar move, Powell could look closer to home: the Fed introduced yield curve controls in 1942 to help finance America’s enormous wartime spending. Our view is that enhanced QE through yield curve controls is a more likely Fed move over the medium term than stock purchases or negative rates.
• Bring back forward guidance
  A key communications tool from the Great Recession until 2016, forward guidance provided markets with a clear picture of the Fed’s intentions on rates and other policy. Given the severity of COVID-19’s economic impact and the degree of monetary response, we think the Fed may revive the practice to help manage investor expectations, especially if and when it begins to unwind its crisis-response programs and engineer a recovery toward “normal.”
• Increase Main Street lending programs
  The Fed’s actions over the past few weeks have largely addressed capital market liquidity. The priority going forward is clearly Main Street, not Wall Street. The solvency risk for households and small businesses is acute, as many have only weeks to months of financial reserves to weather the lockdown. Further cash infusions and loans will be essential to help cushion the economic impact of the virus. In our view, this will be the Fed’s primary area of focus in the near term.Of course, we don’t know yet what that new normal will look like. But we do know that the Fed has already demonstrated that it will do “whatever it takes” to help the economy get there. It will likely still have to go further.

  David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc.  is a regular contributor to AGF Perspectives.
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This post was first published at the AGF Perspectives Blog.