The majority of the messages we received in response to the FOMC’s 50 bp emergency easing this morning were critical. We have often been critical of Fed policy targeted at lifting a flawed inflation measure towards their 2% target, however, the Fed’s original mission was to be lender of last resort during a financial panic. As we detailed in our latest note “GI Joe with the Kung Fu Grip”¹, we are in the midst of a financial panic. All of the post-crisis analysis concludes that when the Fed’s policy rate gets close to the effective lower bound (zero rates), policy action has to be more aggressive. Chairman Powell’s explanation for the rate cut was that their policy is intended to prevent a tightening of financial conditions and boost household and business confidence. He also mentioned their supervisory role. This is a likely next step, like the early ‘90s during the S&L Crisis, the Fed and other bank supervisors are likely to guide member banks towards regulatory forbearance and easier credit standards.
¹https://ironsidesmacro.substack.com/p/gi-joe-with-the-kung-fu-grip
The reaction to the Fed policy response began with the Friday afternoon’s statement from Chairman Powell. Since that point, the yield curve has steepened aggressively, 5s30s are at the widest level since the Fed began balance sheet contraction in 4Q17. Market implied inflation increased, swap spreads are wider as are cross currency basis swaps, Credit spreads tightened and the high grade market reopened this morning. The dollar index has fallen more than a percent, equities have rallied and our market measures of risk are off their most extreme levels, though they remain elevated. Thus far, their attempts to avoid a tightening of financial conditions are working. For those that are thinking the FOMC could reverse the emergency cuts if the economic impact turns out be transitory, we would remind you a Milton Friedman quote, ‘there is nothing as permanent as a temporary government program’. We are skeptical they will reverse today’s cut prior to the November election.
Figure 1: Equity index measures of risk remain elevated, the Treasury volatility index is pointing towards a major refinancing boom and policy uncertainty remains high. Perhaps the most critical of our measures are credit spreads, while they widened sharply they remain in the middle of their post-crisis range.
Prior to last week’s panic we had planned to write about potential Fed rate caps, it won’t be long before we are discussing additional large-scale asset purchases. For now, the Fed had little choice and are unlikely to reduce their $60 billion of Treasury bill purchases per month anytime soon. The Fed acted as the lender of last resort in a financial panic, that is their most important function. It appears to us that critics are conflating post-crisis overly interventionist policy with today’s actions. Criticisms of Friday’s verbal easing and today’s emergency rate cut are misguided. The Fed had no choice, on the margin it is a plus.
Barry C. Knapp
Managing Partner
Ironsides Macroeconomics LLC
908-821-7584
https://ironsidesmacro.substack.com
https://www.linkedin.com/in/barry-c-knapp/
@barryknapp
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