Market Response Doesn’t Mean the Fed Is Useless

(Bloomberg Opinion) -- Financial markets met Tuesday's emergency interest-rate cut with a fresh wave of equity selling and bond buying. This probably wasn't the reaction Federal Reserve Chair Jerome Powell was hoping for. Did the central bank just make things worse? This probably isn't the right way to think about the current situation.

The week so far has had a classic “buy the rumor, sell the news” feeling as market participants surged into risk assets Monday on expectations of policy easing amid the growing coronavirus crisis, and then rushed back out on the news of that action the next day. I am not terribly surprised. We are still much closer to the beginning than the end of this episode. We don't know the width or the depth of the river we are crossing, and we can't clearly see to the other side yet.

Realistically, the only thing that is certain right now is that we will see more “tape bombs” in the days ahead. The bad news is only going to keep coming in the form of more infections, more deaths, and more economic disruption. Rate cuts alone won't change this narrative. That will only happen when market participants have a better idea of the toll the virus will take on the economy. In the meantime, it's completely reasonable for market participants to focus on worst-case scenarios. This is especially the case given the lack of preparedness we have seen from federal authorities. Particularly glaring is the delay in testing. We can't know the magnitude of the crisis when we can't get people tested. So for the foreseeable future, incoming news will support a “risk-off” environment.

This doesn't mean, however, that the Fed shouldn't cut rates. The central bank can't let markets slide indefinitely without circuit breakers and it can't sit on its hands in the face of a demand shock it knows is coming. Doing nothing would only worsen the depth and duration of the downturn ahead. But by taking action with the rate cut – and likely subsequent reductions – the Fed can help cushion the fall and speed the eventual recovery.

And so we shouldn't view Tuesday's plunge as a sign that easier Fed policy is useless. Juicing the markets in the short run isn't the aim here; the goal is sustaining market function and the economy.

In the near term, easier monetary policy supports financial market functioning and sustains the flow of credit in the economy even as risk assets sell off. Such support is critical to preventing the development of recessionary dynamics. In the medium term, lower rates will support risk appetite as market participants begin to gain some clarity on the magnitude of the downturn. And in the longer run, lower rates will support the rebound of spending and with it a more rapid return to normal levels of activity.

The Fed will likely deliver more rate cuts in the weeks ahead. With inflation low (and, for some policy makers too low), there are few risks to easing and potentially very high rewards in the form of avoiding recession. It is too early to declare that policy rates are going to zero, though that certainly might happen if the Fed believes the economy is at great risk of recession.

Be aware that even cutting rates to zero may not create a sustained “risk-on” environment in the short run. But don't let the lack of positive market response be a reason to question the efficacy of monetary policy. The benefits might not be immediately evident right now if all you are looking at is the response of equity prices. But those benefits are real.

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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