In a surprise move on Sunday night, the Federal Reserve cut its short-term interest rate to the 0% to 0.25% range and announced a series of moves to address the economic threat posed by the novel coronavirus. The central bank used a full range of its potential policies to support the economy and financial system. These are the steps that it has taken:
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The federal funds rate was cut to near zero: The federal funds rate is the interest rate banks charge each other for overnight loans to meet reserve requirements. This key policy rate was cut by 100 basis points, or one percentage point, to a range of 0% to 0.25%.
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The discount rate was cut to 0.25%. The discount rate is the interest rate the Fed charges commercial banks and other financial institutions to borrow money through the Fed’s discount window process. The cut is meant to encourage banks to use the discount window if liquidity is needed.
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The Fed provided forward guidance: The Fed indicated it will use its tools to keep the economy functioning until it emerges from the crisis.
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Quantitative easing plan was announced: Over coming months the Fed will increase its balance sheet by at least $700 billion, by buying $500 billion in Treasuries and up to $200 billion in mortgage-backed securities. When the Fed purchases securities, it injects cash into financial markets.
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The Fed will increase the liquidity in financial markets: The Fed is coordinating with other central banks to open and expand swap lines. It will also increase repo operations to offer at least $175 billion in overnight repos each day, at least $45 billion in two-week repos twice per week, and $500 billion in one-month term repos and $500 billion in three-month repos each week.
All of these measures are designed to maintain liquidity in the financial system and support the economy as it deals with the impact of COVID-19 on the global economy.
The Fed’s actions came in response to signs that financial markets were beginning to freeze up last week. It is an aggressive move, and the timing of it—ahead of the previously scheduled Federal Open Market Committee (FOMC) meeting on March 17-18—suggests Fed officials saw no reason to wait. One committee member, Loretta Meister of the Cleveland Federal Reserve Bank, dissented, instead preferring a rate cut of just 50 basis points, or 0.50%.
What’s next?
We believe short-term interest rates are likely to remain near zero for an extended time period, as the Fed indicated these actions will remain in place until the economy reaches the Fed’s goals of full employment and price stability. That could take quite a while, considering inflation has been below the Fed’s target for a few years and the unemployment rate is likely to rise.
The Fed could move short-term policy rates to negative territory, but there doesn’t appear to be much support among FOMC members for that move. In fact, when asked at the press conference about the potential for negative interest rates, Fed Chair Jerome Powell reiterated that the committee did not see negative rates as an appropriate policy response in the United States. Another option would be to provide funding for banks to lend to corporate borrowers in need, similar to a program in Europe.
Going forward, the Fed may consider purchasing corporate bonds as part of additional quantitative easing measures, which could help pull corporate bond yields lower. However, that seems unlikely in the near term, as it would require amending the Federal Reserve Act.
How will markets react?
Stock futures dropped Sunday night after the announcement. In general, the moves by the Fed should be supportive to markets by alleviating concerns that the medical emergency created by COVID-19 could become a financial crisis. However, further government fiscal policy moves likely will be needed to provide underlying support to the economy.
Treasury yields, which had risen late last week, will likely move lower. Credit spreads—the difference between Treasury yields and yields on corporate bonds of comparable maturities—have risen sharply lately. Easier Fed policies might help alleviate some of those concerns, but spreads may still move wider if the economic outlook deteriorates.
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