When Rate Cuts and Quantitative Easing Fall Flat

Fed rate cuts may be less effective at boosting the economy or markets as societies grapple with the spread of COVID-19, but other policy measures may help.

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.