The plunge in the 10-year U.S. Treasury yields over the last week reflects the growing anticipation that the Fed and other central banks will cut rates and use other policy tools, including quantitative easing, to keep financial conditions from tightening during this period of volatility.
At a minimum, we expect the Fed to ease by another 50 basis points (bps) at its next meeting on 18 March – but given recent developments, they may not wait. And over the next several months, it’s a distinct possibility that rates will get cut back to zero. In fact, according to the Fed’s own macroeconomic model of the U.S. economy, roughly four cuts are needed to offset a 1% shock to GDP growth.
Yet, rate cuts alone won’t be the panacea. Monetary policy, which works through long and variable lags, cannot stop the spread of the virus, nor is it particularly effective at addressing supply-side shocks. Similarly, with longer-dated Treasury yields already at historically low levels, quantitative easing – e.g., large-scale purchases of longer-maturity Treasuries or other U.S. government-guaranteed bonds – will likely have limited effect against this unique shock.
How could the Fed help?
A more useful policy response, in our view, would be the revival of some of the Fed’s crisis-era targeted lending operations. Or if Congress, in addition to increasing funding for the health care sector, set up targeted programs to support businesses – especially small and midsized businesses – and consumers facing cash flow disruptions related to social distancing or quarantines. While we have yet to see strains in funding markets, which could constrain credit, including no material movement in cross currency bias, policy makers should preempt possible strains with targeted programs. A liquidity crisis can become a solvency crisis under a more prolonged disruption.
For instance, the Fed could revive its crisis-era facility that funds commercial paper, which could reduce the borrowing costs of businesses and allow them to more easily secure and roll over short-term loans to bridge funding gaps through what most likely will be a temporary disruption.
The Fed also could help ease strains in funding markets. The foreign exchange swap lines with other central banks could help ensure global markets are flush with U.S. dollars, while term repo funding could promote market liquidity by providing short-term loans to banks and primary dealers, collateralized by U.S. Treasuries, agencies, commercial paper, or other bonds.
For policy more directed to small and midsized enterprises (SMEs), the Fed could work with banks on forbearance schemes that are backstopped by Fed liquidity facilities. For example, in the wake of the 2008 financial crisis, the Fed explored (though did not enact) a funding for lending program, which would have provided a subsidized rate of discount window borrowing for banks lending to SMEs.
Finally, a couple of colleagues recently wrote about how the Fed could contribute to lowering mortgage rates, helping the housing sector and the economy, by maintaining the mortgage-backed securities on its balance sheet.
What can’t the Fed do?
Last Friday (6 March), Boston Fed President Eric Rosengren called on Congress to expand the Fed’s powers to buy and sell a broader range of assets. According to the Federal Reserve Act, the Federal Reserve can only buy obligations that are fully guaranteed (explicitly or implicitly) by an agency of the U.S. government. Based on this, it would take an act of Congress for the Fed to add large-scale purchases of equities or credit securities to its regular toolkit. And if the past is any indication, Congress is unlikely to act until there is a crisis.
How has the growth outlook changed?
Next week, we think Federal Reserve officials could slash their 2020 real U.S. growth forecasts to 1%–1.5% when they release the Summary of Economic Projections (SEP) in conjunction with the March meeting statement. Although the full-year forecast would still be positive, this revised forecast would imply that the U.S. comes close to sliding into a technical recession (two consecutive quarters of negative growth) on a quarterly sequential growth basis.
On top of the drag from supply chain disruptions, slower energy investment due to lower oil prices and lower consumer services spending due to COVID concerns are also likely to weigh on growth in 2Q and 3Q, and could drag the broader economy into a small contraction. Indeed, some of the hardest-hit areas include travel, tourism, recreational services, food services, and other consumer services, which combined make up over 10% of U.S. GDP, according to the Bureau of Economic Analysis.
Furthermore, it’s important to keep in mind that 24% of American workers lack access to paid sick leave, according to the Bureau of Labor Statistics. Under a hypothetical scenario, we estimate that a two-week reduction in aggregate wages if 40% of the population with unpaid leave got sick would reduce quarterly annualized U.S. aggregate income growth by 1.6 percentage points.
Still, it’s important to keep in mind the wide range of scenarios around the virus itself, and its impact on economic activity. Much of the public discussion so far has focused on a growing and material outbreak in the U.S., but the shock could also be milder than expected, or the U.S. economy more resilient. Ahead of the virus’s outbreak in China, U.S. economic fundamentals were improving. The growth impulse from housing and construction activity was providing a solid buffer against slower consumption and still-weak investment and export growth. Furthermore, we were seeing a pickup in activity in acyclical sectors such as health care and education, which could further buffer an economic shock.
For insight into PIMCO’s global outlook amid rapidly shifting markets, please see “Economic Outlook Update: ILU Trajectories”.
Tiffany Wilding is a PIMCO economist focusing on North America and is a regular contributor to the PIMCO Blog.