One good rate cut deserves another
admin | March 6, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The emergency intermeeting 50 bp rate cut by the Fed on March 3 raises the question of how the Fed has followed up such moves in the past. Since the FOMC began to announce its decisions and focus most of its rate moves at meetings, it has cut rates intermeeting six times. In every one of those cases, the Fed has eased again at the next FOMC meeting. The history of emergency cuts offers some lessons.
Intermeeting rate cuts
Under Chairman Alan Greenspan, the Fed in 1994 began to announce its rate moves. As a result, the Fed started to raise or lower rates predominantly at FOMC meetings, when the committee could discuss the environment and easily sign off on a statement. Over the ensuing 26 years, the Fed has cut rates intermeeting six times (Exhibit 1). In every instance, the Fed followed up with another easing at the next regularly scheduled FOMC meeting.
Exhibit 1: A history of intermeeting rate cuts—one good cut deserves another
1998 Financial market meltdown
In 1998, the economy was generally performing well, but the financial markets had a severe meltdown. Russia devalued its currency and defaulted on some of its sovereign debt in August, setting off a domino effect that ultimately took down Long-Term Capital Management, a highly levered hedge fund that had immense positions in a number of illiquid markets. The New York Fed was forced to assemble Wall Street dealers in late September to craft a bailout of LTCM to avoid default and a broader collapse in financial asset prices. Then, the FOMC responded by cutting policy rates by 25 bp at its regularly scheduled meeting on September 29.
Financial conditions continued to deteriorate in early October and by the middle of the month, risk spreads were blowing out. IG spreads had widened by a total of 50 bp, the spread of BBB corporates to Treasuries roughly doubled from its normal width to around 650 bp, and even swap spreads and on-the-run/off-the-run Treasury spreads blew out. The stock market overall did not decline alarmingly in that period, but financial stocks in particular took it on the chin, with bank and investment bank stocks losing 20% to 25% of their value in 1998.
In response, Chairman Greenspan conducted a conference call on October 15 and then announced a 25 bp rate cut late in the day. Stock prices surged and continued to gain further over the balance of October. Risk spreads came in and the new issue window reopened, but strains did not disappear entirely. By early November, concerns regarding year-end funding pressures were creating tension in money markets. With this backdrop, the FOMC met on November 17, 33 days after the emergency move, and decided to add one more 25 BP dollop of ease. The minutes reflect that several members viewed the decision as a close call, but the desire to further bolster financial conditions won out. The post-meeting statement suggested that the committee felt it had done enough, and, indeed, there was no further easing. The economy continued to grow at an unsustainably rapid pace, so the Fed’s insurance cuts could be said to have done their job, but the Fed was slow to reverse course, as it did not raise rates until June 1999 and took a full year after the last cut to get back to the pre-September 1998 policy setting.
After several years of red-hot growth, the economy began to roll over in late 2000. At the December 2000 FOMC meeting, the Fed saw that conditions were softening and while there was no immediate move, the balance of risks was shifted to the downside and the committee discussed the possibility of needing to move in early January if the data continued to deteriorate. It did, and Chairman Greenspan conducted a conference call on January 3 and gained consensus for a 50 BP rate cut. Further 50 BP cuts were adopted at each of the next two FOMC meetings.
A similar dynamic occurred in April, when the Fed again called an intermeeting conference call about halfway between an unusually long (8-week) intermeeting period and cut rates by 50 bp on April 18. Through August 2001, the Fed moved at every FOMC meeting and twice in between meetings to boot, for a total easing of 300 bp.
It is worth noting that the Fed began 2001 with a 6.50% funds rate target, so it had a long way to go to get to an appropriate setting in the context of a recession. Lowering rates by 300 bp in 8 months was somewhat unusual but not entirely shocking given the meltdown in tech stocks and the deterioration in economic activity.
The third intermeeting move of 2001 was quite different. Six days after the World Trade Center attacks, as the financial market were reopening after being shut for the balance of that week, the Fed cut rates by 50 bp. It followed that up with cuts at each of the three remaining regularly scheduled meetings over the balance of the year, taking the funds rate target down to 1.75% by year-end.
While the 2007-2008 recession is mainly remembered for the meltdown in October 2008, the economy had begun to weaken as early as late 2007, and financial conditions began to unravel in the summer of 2007. In fact, the Fed had already eased three times by a total of 100 bp by the end of 2007. As the calendar turned to 2008, the economy began to really head south. Chairman Bernanke actually held a conference call on January 9, where he suggested that he had almost asked for a consensus to ease immediately, but had decided to wait, and the FOMC agreed that the default path should be to wait until the next FOMC meeting.
However, the Fed did not make it to the next meeting, as Chairman Bernanke reconvened the committee by phone on January 21 and explained that events were moving too fast. The equity market had declined by about 5% in the previous week and futures were down another 5% or so on that day. Concerns about monoline insurers were also roiling a variety of fixed income markets. On top of that, the economic data had worsened both in the U.S. and globally. Thus, the Fed acted, slashing the funds rate target by 75 Bp on the following day (before the stock market opened), even though the meeting was only a week away. The FOMC followed up 8 days later with another 50 BP ease at its regularly scheduled meeting. Most policymakers believed that the economy had deteriorated so rapidly that its policy stance was far too tight and thus the double dollop of rate cutting would help the Fed get to their desired policy setting more quickly.
Indeed, the FOMC continued to ease in March and April of 2008 (around the time of the Bear Stearns collapse), but then conditions appeared to stabilize in the spring and summer. However, the economy and financial markets began to fall apart by September, forcing the Fed to meet on October 7 and to implement a 50 BP easing on October 8. That move was coordinated with several other central banks to present a united front. Of course, in retrospect, financial conditions continued to crater, with the Lehman and AIG collapses, among other calamities, and the FOMC ended up taking its rate target to effectively zero before the end of the year, including a 50 BP cut at the next FOMC meeting in late October.
Characterizing the moves and looking ahead
Broadly speaking, the six intermeeting rate cuts fall into two categories. Three of the rate cuts were garden-variety easing, when the Fed found itself well behind the curve in the early stages of a recession (January 2001, April 2001, and January 2008), while the other three instances were more event-driven (the 1998 financial market meltdown, the 9/11 terrorist attack, and the October 2008 financial collapse), though even the September 2001 and October 2008 moves came during recessions.
In any case, the Fed looks unlikely to buck the historical trend. The FOMC looks most likely follow up with an ease at its next regularly scheduled meeting on March 17-18. Expect 25 bp, although financial markets are working hard to force the Fed to do more. One reason to expect a smaller move later this month is that, unlike most of the prior episodes, the Fed came into this period with policy already in an accommodative stance. Moreover, the event precipitating the emergency ease is generally believed to be strictly temporary. The Fed may choose to be more aggressive, but at this time the odds lean toward a smaller move, with the next ease, like the one on November 1998, presumed to be the last one depending of course on how the coronavirus evolves.
There’s another similarity between the current situation and the 1998 episode. Assuming that the effects of the coronavirus come and go over the next several months, the Fed is presumably going to need to take back the accommodation provided this month. The main question is the timeframe. The 1998 episode is the clearest but by no means the only illustration of the Fed’s asymmetry when it comes to rate moves: quick to ease and slow to tighten. Just as the Fed took too long to reverse the 1998 easings, helping to contribute to the overheating in the economy and in financial markets that eventually led to the 2001 recession, the Fed will probably be slow to reverse itself again this time around. In general, there will be no urgency to tighten with inflation likely to be relatively well-behaved. Moreover, with the election looming and President Trump highly critical of the Fed, the bar for any rate hike prior to November is likely to be extremely high. Even in relatively benign outcomes related to the coronavirus, the Fed seems unlikely to even begin to take back whatever easing is put into place this year until December at the earliest.