On Tuesday morning, shortly after the market opened, the Fed did what other central banks concerned about the coronavirus didn’t do, and that was cut its policy rate. Not only did it cut the rate, it did so by 50 basis points, dropping its policy rate to the range of 1%–1.25%.
As the chart below of the Dow Jones Industrial Average shows, the market’s reaction was initially positive, but that optimism lasted only about an hour, as market participants began to digest what the rate cut might or might not accomplish. By about 11:30 AM, the market had dropped over 400 points and then continued to slide, closing about 800 points below the open.
The Fed’s move was clearly intended as insurance designed to convince participants that the Fed will do what it takes to support the economy in the face of the coronavirus threat. As the day proceeded, however, the realization set in that rate cuts aren’t medicine when it comes to the threat of a pandemic. It can’t get consumers out of their homes to spend and it can’t fix supply chain bottlenecks. Furthermore, financial conditions were extremely accommodative even before the rate cut. Given the number of unknowns about the virus and the criticism of the government’s handling of the crisis so far, it was logical for market participants to ask, “Does the Fed know something they aren’t telling us?” Were conditions so dire that they could not wait two weeks until the next FOMC meeting?
We don’t entirely know why the market responded the way that it did. Did algorithmic trading play a part in the sell-off, for example? We do know that investors shed equity holdings and bid up Treasury prices, with the 10-year Treasury closing below 1% for the first time ever.
The most likely explanation for the market’s behavior is that we are looking at a classic case of uncertainty. No one knows how the virus will spread within the US or what the domestic and international economic consequences will be. It is arguable that the Fed may have exacerbated market concerns and thereby, contributing to that uncertainty by its actions, rather than providing comfort or the insurance that it sought to supply. There is no economic theory, as we have argued in previous commentaries, that tells us how monetary policy will work when we can’t reasonably estimate the probability of various economic outcomes, and this case is no exception. While we don’t know how the markets would have responded if the Fed had not acted, the Dow was clearly on a positive track. Interestingly, following Super Tuesday’s election results, market participants on Wednesday seem to have largely shrugged off the Tuesday market decline, adding over 1,170 by the end of the day. The rally was apparently buoyed by the election results and the House’s passage of a bill authorizing $8.3 billion to combat that Coronavirus, with healthcare stocks leading the rally. However, on Thursday, March 5 the index again slumped as focus again returned to the economic impact of the Coronavirus. The bottom line is that it looks like the Fed simply wasted 50 basis points of ammunition when the alternative would have been to wait, as other central banks had decided to do.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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