We agree with markets that the Fed’s intermeeting rate cut has opened the door for a move back towards the zero lower bound. In the Eurozone the ECB may be compelled to do more than offering indirect liquidity support to businesses, which is the move being contemplated by the BoJ. Indeed, we believe a rate cut and a temporary increase in the pace of net QE is becoming more likely by the day. Finally, in China, the PBoC is on a measured, targeted easing path. We believe that the focus of the PBoC will gradually shift from providing liquidity to using the interest rate channel, as Fed easing and forthcoming inflation falls pave the way for further cuts.
With the rapid moves of the past weeks, our scenarios for central bank easing are now fully priced in, except in China.
There are a couple of aspects to the Fed’s intermeeting rate cut of 3 March which might help explain their thinking and point to possible next steps. First, with official rates already close to zero, the Fed has less ammunition to support the economy once it moves into a recession. This flags the importance of preventing the economy from getting to that point, and hence the Fed’s desire to move early.
Second, the Fed’s communication to markets over the past year has been far from effective. In 2018-2019 the Fed acted late to signs of overtightening and was heavily criticized for this. The FOMC probably felt forced by the market to ease in 2019, making it more difficult to surprise in a dovish way, which in turn reduced the effectiveness of its actions. So, it would have taken that into account.
And 2020 is special. Although the Fed is independent, it probably would not want to be accused of acting too slowly in a possible health crisis. Nor would it want to feel forced to act at the meetings surrounding the Presidential elections on 3 November. By making an early move, they are back ahead of the curve and can avoid possible awkward timing.
Fourth, by moving quickly the Fed made it easier for other central banks to pursue an easier policy, without the risk of being labeled a ‘currency manipulator’. Ultimately, monetary easing elsewhere will also support the US economy. Intermeeting cuts are not unique. Between 1998 and 2008 this happened seven times (including one discount rate cut in August 2007). All of these intermeeting cuts were followed by additional easing.
Taking into account the Fed’s 50bps emergency cut and recent price action in European bond markets, we feel the ECB will be forced to do more than ‘merely’ announcing indirect liquidity support to businesses. Indeed, they will likely complement this with a 10bps cut in the deposit facility rate, which is fully priced in by April, and with a temporary increase in the monthly pace of net asset purchases, notably those of corporate bonds.
We think any step-up in the pace of net QE will be measured and temporary – conditional on the evolution of downside risks emanating from the virus outbreak.
The initial response of Chinese policymakers to the economic harm caused by the coronavirus outbreak seems to have been aimed at supporting cash-constrained SMEs, via fiscal-type measures such as targeted tax and cost cuts, and targeted liquidity and credit support. More recently, with the outbreak seemingly moving in the right direction, the focus of authorities seems to be shifting to stimulating demand, especially through infrastructure investment.
Looking ahead, it seems reasonable to assume another 10bps cut in both the 7-day repo and 1-year MLF rate later this month. The emergency 50bps rate cut by the Fed – and recent strengthening of the CNY – arguably has given the PBoC more scope to do so. On top of this, we have penciled in another 10bps of rate easing in our central scenario for H1. Besides this we expect another 50-100bps cut in (small) banks’ reserve requirement ratio (RRR). Since we see a real possibility – given the virus outbreak outside of China – that the recovery in China could be slow to unfold, the risks around this baseline scenario seems to be skewed to even more rate cuts. These, however, could be more slowly delivered than is typically done by central banks in developed markets.
With interest rates already quite low, and given that the authorities recognize that the coronavirus is creating a supply shock with near-term consequences at the very least, we expect that the Japanese government and the BoJ would consider fiscal policy measures to be more effective than monetary policy measures.
That said, our view at this point is that the BoJ is likely to maintain its preference to keep the short-term policy rate from moving deeper into negative territory – barring any sharp yen appreciation.
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