Another Bad Week for Markets Will Force the Fed's Hand

(Bloomberg Opinion) -- The Federal Reserve finally succumbed to rising pressure from financial markets that have been roiled by the widening coronavirus crisis with its pledge Friday to “act as appropriate to sustain the expansion.” I suspect central bankers hope the move will buy them enough time to forestall a rate cut until the March meeting. It’s not obvious yet that they will get that time. Another week of free-falling markets would force their hand on an inter-meeting cut.

Despite repeated denials that it was too early to consider a policy shift, the Fed eventually recognized that they couldn’t let markets slide day after day without a firm indication that it remained the backstop for the economy. The language of the central bank’s statement was the same used by Chair Jerome Powell last June. Then, like now, it signals an imminent rate cut, likely at the Fed meeting this month on March 17-18.

The Fed isn’t going to like cutting rates ahead of data that would justify a reduction. They still would prefer to view the virus as a temporary hit to the economy, much like a natural disaster. On one hand, that is a completely reasonable view. On the other, it is completely unrealistic at this point. The Fed cannot let panic on Wall Street continue because it would  threaten the economic health of Main Street. The free flow of credit needs to be sustained and that requires circuit breakers to ensure that what so far has been an orderly sell-off doesn’t get out of control.

Moreover, falling yields  on U.S. long-term bonds indicate that market participants anticipate a disinflationary negative demand shock. The Fed will need to ease policy in response. While financial market participants may be overeating – they usually get the direction right but the magnitude wrong – central bankers can’t know that just yet. Perhaps more importantly, given the economy’s proximity to the zero lower bound for interest rates, the Fed very much needs to err on the side of caution to prevent a recession.

Try as they might, the Fed may not be able to delay the rate cut until the next meeting. That very much depends on the ability of financial markets to stabilize this week. Odds are that they will continue to struggle instead. On Saturday, the first U.S. death from the COVID-19 virus was reported in Washington state, and new cases there as well as in Oregon and California reveal the disease is spreading in the community. It is reasonable to expect the number of confirmed cases in the U.S. to start climbing – and we are still at the point where every new development is a potential tape bomb.

Financial market participants also struggle with a lack confidence in the ability of the Trump administration to manage a crisis. The fear is that the administration will prioritize politics over public health, and in the process worsen the spread of the virus and create a greater sense of panic among the public. But it cannot suppress negative news here. There are simply too many state and local health authorities that will reveal the extent of the spread. Efforts to deny the evolving crisis will result in more tape bombs, though it appears the administration is beginning to sound a more sober message and in some areas step up its response, such as its move Saturday to clear the way for faster diagnostic tests.

To be sure, market participants might shrug off bad news this week. If so, the Fed could stay on its preferred course and hold off on further action. Because we are still in the early stage of the virus spreading in the U.S., however, the risk is weighted in the direction of continued turmoil in financial markets. The Fed may have little choice but to step in with inter-meeting action, particularly if the downdraft turns into something that threatens to become a larger credit event. Like it or not, the Fed can’t let Wall Street slide indefinitely on the hope that Main Street can walk away unscathed.

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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