When the Fed and markets move together it is difficult to figure out who is watching whom — former Fed chair Ben Bernanke called it the "hall of mirrors" problem.
Giving investors what they want is precisely what the Fed seemed to be doing on Tuesday, when it announced its first emergency rate cut since the height of the financial crisis. But in a hastily assembled news conference, Fed chair Jerome Powell laid out a simple justification for its actions.
He suggested that when there is great uncertainty and no historical precedent for what is about to happen, the best thing is to do whatever you can — even if you do not have great tools for the job. As the number of coronavirus cases in the US passed 100, Powell indicated he had no other choice. But he was forthright about what he did not know.
"For us what really matters is not the epidemiology, but the risk to the economy. So we saw a risk to the economy and we chose to act," he said.
The move came after days of increasingly urgent signals from markets. A week ago investors assigned zero probability to a single rate cut at the Fed's next scheduled meeting on March 18 according to analysis by CME Group; by Monday, they were already anticipating two cuts.
The Fed is doing "what the bond market says — with a lag", said Jeffrey Gundlach, who oversees more than US$155 billion ($246.6b) in assets. The bond market "definitely helped to encourage" the Fed to take action, he said.
Rick Rieder, BlackRock's chief investment officer of global fixed income who oversees the group's US$2.3 trillion bond portfolio, said the Fed "almost had to do it" given how elevated investors' expectations were for additional easing.
"Financial markets are now much more important than they have ever been before," he said.
Loretta Mester, president of the Cleveland Fed and a voting member of the Fed's rate-setting committee, echoed Powell's uncertainty in a speech in London. "Both the magnitude and duration of the economic effects of the virus are highly uncertain," she said.
Unknowns include the actions of other countries and public health officials, and the characteristics of the disease itself, Mester said.
The Fed is probably looking at more than just the market rout, which has begun to ripple through to businesses. Turbulence in the markets forced companies to postpone debt deals last week; there were no new corporate bonds or leveraged loans sold in the US, according to data from Refinitiv — a rare occurrence outside the seasonal year-end slowdown or summer doldrums at the end of August. Globally just US$41b of debt was sold, less than half the prior week's total.
"You had better believe that this is one of the things Fed chair Powell was paying attention to," said Danielle DiMartino Booth, chief executive of Quill Intelligence, a research company, and a former adviser at the Dallas Fed.
On Tuesday both Powell and Mester mentioned several specific industries that were already experiencing a slowdown: travel and tourism companies, and manufacturers that rely on components from China.
According to Claudia Sahm and David Wilcox, both former heads of research divisions at the Fed's Board of Governors, policymakers are probably talking regularly to their extensive networks of regional business contacts.
"They almost certainly activated that network last week if not the week before," said Sahm. "They talked about the coronavirus at the last meeting. They're watching this . . . I hope it doesn't get bad, but they'll be the first to know."
This leaves open the possibility that Tuesday's emergency rate cut was just the first of a series of policy easing measures.
Powell said the Fed's committee had not yet considered alternative monetary policies such as asset purchases or forward guidance about future decisions. But by the end of the day key US stock markets were down almost 3 per cent, the yield on the US 10-year Treasury dropped to a record low and US president Donald Trump demanded even more easing.
But some economists and investors say monetary policy will have limited effectiveness.
"I don't think [rate cuts] will have a true economic impact at all," said Rieder, noting instead that policies to help small business lending, among others, would be more effective. "[Coronavirus] is completely unknown and unlike virtually anything else. It is an exogenous shock that is not much different than [the financial crisis in] 2008, because you just don't know how the world will react."
That piles pressure on the US government to prepare for fiscal stimulus; other governments hit by coronavirus, including South Korea and Italy, have already launched spending packages.
Central bankers across the developed world have warned for years that — because interest rates are so low — their ability to combat a sustained global economic slowdown is limited, in comparison to the fiscal options available to governments.
In January, Bernanke and Janet Yellen, another former Fed chair, said the central bank might not have enough tools to respond to the next downturn, and asked Congress for a better plan for a fiscal response. Speaking to Congress in early February, Powell added to the clamour; the Fed openly acknowledges that it does not have perfect tools for any downturn, and this downturn in particular.
But with the White House still non-committal on a fiscal stimulus, a swift and dramatic rate cut was the best the Fed could do.
"It seems to me they're in a situation where there's really nothing to be lost and there might be something to be gained," said Wilcox.
Written by: Brendan Greeley, Colby Smith and Jennifer Ablan
© Financial Times