S.F. Fed letter touts benefits of early rate cuts

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Although there’s still no way to tell how long the COVID-19 shutdown will last, or how much economic damage will result, the Federal Reserve’s speedy descent to the zero lower bound will assist the recovery, according to a report.

“The full impact of the pandemic on the economy is still uncertain and depends on many factors,” writes Vasco Cúrdia a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco in an Economic Letter. “Analysis suggests that allowing the federal funds rate to fall fast will help the economy cope with the aftermath of COVID-19. In particular, the limited policy space due to the effective lower bound of the federal funds rate before the pandemic reinforces rather than offsets the need for a rapid funds rate decline.”

While the Fed action should stabilize yields, as liquidity improves, Subadra Rajappa, head of U.S. rates strategy at Societe Generale says, “it is too early for a victory lap, as we need to see clear sign of the flattening of the COVID-19 curve and potential for things to get back to normal.”

However, she notes, “recurrence and recontamination remain serious risks. In this context, we expect the 10-year Treasury yield to dip to a low of 40 basis points by end-of the second quarter, but gradually rise over the remainder of the year.”

The United States responded to the coronavirus with massive “monetary and fiscal stimulus,” and therefore it will “lead the way in a recovery,” she added.

Although the Centers for Disease Control remains optimistic the peak is near, no timetable can be set for when New York City, the hardest hit by the virus, will be able to remove restrictions and return to normal.

In a televised interview, Federal Reserve Vice Chairman Richard Clarida said the drop in demand is “dis-inflationary,” not “deflationary,” and the Fed has “the tools to keep the economy out of deflation and to support the economy through this challenging period.”

While no data was released Monday, on Friday, the Bureau of Labor Statistics reported the March consumer price index fell 0.4% and was up 1.5% from a year ago, while the core dropped 0.1% in the month. The core rate gain on an annual basis dropped to 2.1% from 2.4% a month earlier.

Economists polled by IFR Markets expected the headline number to fall 0.3% in the month, with the core rising 0.1%, while year-over-year the headline number gain was expected to be 1.6% and the core 2.3%.

“Details are consistent with our view of a slowdown in core price growth, rather than substantial and broad-based price declines in 2020 — think disinflation rather than deflation,” Morgan Stanley Research said in a note. “Markets have significantly overpriced pessimism on core inflation ex-oil.”

Now that the producer and consumer price indexes have been released, Morgan Stanley expects core personal consumption expenditures — the Fed’s preferred measure of inflation will slip to 1.7% on an annualized basis in March from 1.8% a month earlier.

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Monetary policy Federal Reserve FOMC Coronavirus