The Federal Reserve acts again, as market turmoil continues

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Editor’s note (March 16th): This article has been updated to include American stockmarket falls.

Central banks are not known for their spontaneity. They do not tear up their calendars lightly. And when they do, it is not usually a good sign. Both the Bank of Japan and America’s Federal Reserve were scheduled to hold policy meetings later this week. But neither felt they could wait that long.

On March 15th—a Sunday—the Fed cut its benchmark interest rate by a full percentage point, lowering it to the range of 0-0.25%, as low as it has ever gone. It was the central bank’s second emergency cut outside a scheduled meeting in less than a fortnight. The Fed also made it cheaper and more convenient for banks to borrow directly from its “discount” window (an option banks have traditionally avoided because it makes them look desperate). And to ease the shortage of dollars evident in the currency-swap market, it lowered the cost of the swap lines it has extended to central banks in the euro area, Japan, Britain, Canada and Switzerland.

If that was all it needed to do, it could probably have waited until its regular meeting on March 17th and 18th. But it also faced a more urgent problem in two of the most important financial markets in the world: those for mortgage-backed securities and American Treasury notes. In times of crisis, such as recessions, wars or today’s covid-19 pandemic, investors flock to American Treasuries as a safe haven, driving their prices up and their yields down (for more coverage of the pandemic, see our coronavirus hub). But on occasions last week, the price of Treasuries had fallen alongside those of risky assets, such as shares. And unusual gaps had emerged between the prices of closely matched securities, such as Treasuries of similar maturities. Yields had become “wiggly”, as Darrell Duffie of Stanford University described it to the Financial Times.

Ironing out those wiggles is usually the job of hedge funds and other financial institutions that buy the cheaper instrument and sell its more expensive cousin. But this kind of arbitrage seemed to break down last week as financial institutions withdrew from the market and clung to cash. In response, the Fed first tried making it easier for these institutions to finance themselves. Then it began buying more Treasuries itself, accelerating a previously planned schedule of purchases. At the weekend, it said it would buy on a far greater scale, purchasing at least $500bn of Treasuries and $200bn of mortgage-backed securities, at whatever pace is necessary to smooth out the market.

Jerome Powell, the Fed’s chairman, was immediately asked if this buying amounted to “quantitative easing”, the term applied to the Fed’s previous rounds of asset-buying during the Great Recession. But although the purchases look, swim and quack like QE, they have a different purpose: quantitative stabilising, not easing. QE, which is a way to loosen monetary policy when interest rates are already as low as they can go, can be necessary even when markets are functioning smoothly. Conversely, stabilising markets is sometimes necessary even when rates are higher than zero. (Indeed, one member of the Fed’s policymaking board, Loretta Mester, was in favour of the asset purchases but against cutting interest rates by a full percentage point.) Simply put: if these purchases were merely another round of QE, the Fed would not have needed an unscheduled weekend meeting to announce them.

Will further measures be necessary? Certainly these ones failed to restore immediate calm to the markets. Following falls in stockmarkets across Asia and Europe on March 16th, the Dow Jones Industrial Average fell by an astonishing 13% and the S&P 500 index by 12%. After all, Mr Powell himself had pointed out that the economy was likely to shrink in the second quarter, as firms and people hunker down to avoid infection. Growth could be as low as -5%, at an annual pace, according to Goldman Sachs. Efforts to slow the spread of the virus also inevitably slow the economy. In China, which has gone further than most countries to contain the pandemic, industrial production shrank by 13.5% in January and February, compared with the previous year.

Nonetheless, Mr Powell does not think that negative interest rates are likely to be “appropriate”. Nor is the Fed seeking legal permission to buy a wider range of assets, beyond the safe, government-backed securities it is now allowed to purchase.

The Bank of Japan cannot afford to be so particular. It introduced negative interest rates more than four years ago and has been buying equities, through exchange-traded funds (ETFs), for even longer. Although Japan has been more successful than Europe or America in slowing the spread of the covid-19 virus, its economy was already shrinking before the epidemic emerged. On March 16th its central bank said it would buy corporate bonds (and commercial paper) worth ¥2trn ($19bn) by September and double its purchases of ETFs from ¥6trn to ¥12trn a year. But as Marcel Thieliant of Capital Economics, a consultancy, points out, the central bank had already begun buying ETFs at a furious rate over the previous week and that did not stop Japan’s stockmarket plunging.

Other central banks have followed the Fed’s lead: the Bank of Korea and the Reserve Bank of New Zealand also cut rates on March 16th. Central banks, as the Fed’s Mr Powell pointed out on Sunday, can ease borrowing costs and improve liquidity. But they cannot provide more direct help to households and small firms that are suffering during the outbreak. In both America and Japan, central banks are now waiting for a more concerted fiscal response to the covid-19 crisis. “We do think the fiscal response is critical,” Mr Powell said, “we're happy to see that [fiscal] measures are being considered and we hope they are effective.”

One of the most famous meetings in Fed history was held on a beautiful weekend in October 1979. Known as the “Saturday night special”, it heralded a brutally effective campaign against inflation. The covid-19 virus is not a dragon that central banks can slay. But Mr Powell will hope his Sunday night special proves equally effective in quelling the pandemic’s disturbing financial side-effects.

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