The Federal Reserve heads into its first meeting of the new decade with its key responsibility — interest rates — well resolved, but with a slew of other less headline-grabbing but still significant decisions on the table.
Practically no one expects the central bank to move its benchmark borrowing rate until at least September. Central bank officials have made it clear that it would take a meaningful change from current conditions to prompt another cut. There’s also pretty much no chance of a hike absent a sudden jump in inflation.
But officials still will be called on to answer a few key questions:
- What role could the Wuhan coronavirus play in policy terms?
- How much more will the Fed expand its balance sheet?
- Is it time for another technical adjustment on the interest paid on bank reserves?
Wednesday’s rate decision and subsequent news conference from Chairman Jerome Powell likely will provide only hints rather than concrete answers. However, the details of where the Fed stand will be important.
“At best, they can be patient and wait and see and stay to their original script, which is ‘we’re on hold this year,'” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. “If they alter the script, I do think markets are going to be concerned.”
The virus scare
The intensifying coronavirus spread has gotten the market’s attention, both on a human level and the extent to which it could slow economic activity, particularly in China.
Past practice for the Fed has been to acknowledge such events but not to react to them. Policymakers generally view things like natural disasters, epidemics and other exogenous occurrences as one-offs in nature and not a factor in long-term policy decisions.
In a November speech before Congress, Powell said it would take a “material reassessment” of conditions before the Fed would change policy.
“A China-centered global outbreak of a highly contagious disease with a high fatality rate that threatened to derail tentative global economic stabilization – if this is what we are dealing with – could in principle meet the ‘material reassessment’ test, though we do not think Powell will get drawn into this type of judgment at this juncture,” Krishna Guha, head of global policy and central banking strategy at Evercore ISI, said in a note.
The economy more broadly seems to be fairly steady, with the Atlanta Fed projecting fourth-quarter GDP growth to come in at 1.9%. That’s not gangbusters, but it is better than the flat growth the indicator had shown earlier in the quarter.
As a compromise, the Fed could change the language in its statement about the way it is monitoring international developments. Powell also could give a nod to the manufacturing slowdown; the headline durable goods orders for December were better than expected, but masked weak underlying fundamentals.
The repo market question
In addition to broader economic issues, the Fed has been wrestling with the level of bank reserves that the financial system requires.
To ensure that banks have “ample” reserves, the Fed has been conducting daily and longer-term market operations to allow institutions to exchange high-quality assets for the short-term cash they need to operate, in a process known as repo operations. That has allowed the Fed’s balance sheet to expand back above $4 trillion.
While the operation ostensibly was aimed at keeping overnight borrowing rates within their proscribed range, it also has coincided with a stock market rally that has almost perfectly matched the balance sheet increase. Some in the markets have been calling the expansion another form of the quantitative easing the Fed used to goose the economy during and after the financial crisis.
With the Fed only committed to keeping the operations going through the second quarter, cleanly unwinding them could be another nettlesome issue.
“They’re going to be very careful. They attempted to do this in a stealth way, in my humble opinion, for political expediency,” Shallet said. “I think that to start acknowledging that … we’re going to have to suspend the balance sheet expansion by the middle of the year, markets are not going to take that well.”
Powell at times has been less than adroit in how he has prepared the market for a change in approach.
“This is tricky terrain for Powell and if mishandled could be disruptive,” Guha wrote. “That is why we expect only very cautious and limited comments for now, in particular given virus concerns, but see net downside risk on the day.”
There’s also some expectation that the Fed could approve a rate hike, but not the kind that most people generally notice.
Instead, the committee might be tempted to increase the interest it pays on excess reserves that banks store at the Fed. The rate is currently set at 1.55%, but could be line for a nudge up to 1.6%.
The reason is that the Fed uses the IOER as a guardrail for its benchmark funds rate. Over the past two years, the Fed has been cutting the IOER rate as the funds rate has moved to the top of its target band.
But since the repo operations began, the funds rate has slipped to the low end of its 1.5%-1.75% range — currently at 1.55%, same as the IOER. The Fed generally prefers the funds rate closer to the midpoint, so a push higher on the IOER could help make that happen.
With jitters over the coronavirus situation, however, the Fed might choose to wait.
“We do expect an IOER hike over time, but in our view the cost of waiting is very low and the Fed would probably like to avoid to possibly needing to reverse a hike,” Ebrahim Rahbari, forex strategist at Citigroup, said in a note.
Rahbari said markets are pricing in about a 50% chance of an IOER increase. Futures traders are further indicating a 58% chance of a quarter-point decrease in the funds rate by September, rising to 73% by the end of the year.
However, the Fed this week likely will assert that it remains on hold for pretty much everything.
“We think that the Fed will note that even though the outlook for the economy remains benign, it continues to watch risks closely,” Rahbari said. “Chair Powell will remain confident about the outlook, including the prospects for inflation to approach the Fed’s target, but also be watchful of remaining risks, including still-soft manufacturing sentiment readings, and uncertainties around the impact of the corona virus.”