COVID-19 And The Fed: Our Currency, Our Problem Too

The Fed will probably ease in March, in part to help China avoid a hard landing.

Fed funds futures are currently pricing about 1/4 chance of a 25 bp cut at the Federal Open Market Committee (FOMC) meeting on 18 March. I believe that probability is closer to 2/3 for the following 5 reasons.

First, in the runup to the FOMC March meeting, we are likely to see more evidence that COVID-19 early containment is unlikely, as well as more instances of the virus’ negative economic and market impact.  As the country where the epidemic is most advanced, China appears most exposed.

Second, globalization has led to a Fed rethink on the need to take into account the global impact of its policies.  Traditional Fed thinking has been some version of Treasury Secretary Connally 1971 quip that “the dollar is our currency but your problem”.

But since the global financial crisis, Fed thinking has evolved – as shown, for instance, by the establishment of permanent swap lines with global central banks, which is an implicit acknowledgement that shortage of offshore USD can be a threat to US financial stability.

In addition, following the August 2015 CNY devaluation, Chair Yellen indicated that the FOMC had decided to hold off on hiking at the September 2015 meeting due to Chinese concerns. These were, “whether there might be a risk of a more abrupt Chinese slowdown”, as well as “the deftness with which Chinese policymakers were addressing those concerns”. Yellen saw “a very substantial downward pressure on oil prices and commodity markets” that had “a significant impact on many emerging market economies as well as Canada, an important trading partner of ours”.

More recently, an October 2019 Fed paper highlighted that the risks of a Chinese hard landing had increased and that, once the impact on US market sentiment and on US trading partners is taken into account, the US was highly exposed. For instance, US GDP growth could fall by about 1pp in response to a 4pp decline in Chinese growth.

Chart 1: Chinese Private Sector USD Borrowing

Source: Macro Hive, Haver

A March Fed cut would support Chinese financial stability through 3 main channels:

(1) The USD would weaken, which would help China and therefore other EMs maintain a stable currency.

(2) The Chinese private sector, which has borrowed about 1.3 trillion in USD, would find it easier to remain current (Chart 1). Debt servicing difficulties could put pressure on the CNY.

(3) A weaker USD would support looser global liquidity conditions, risk assets, and EMs.

Third, the Fed is unlikely to be concerned by a pickup in inflation related to COVID-19 for the following reasons:

• The Fed views the inflation process as a series of deviations from a long-term trend driven by inflation expectations and is unlikely to get concerned as long as expectations remain anchored. On February 21st, Vice Chair Clarida judged that “inflation expectations reside at the low end of the range I consider consistent with our price-stability goal”.

• The US economy is services-driven: core goods are more exposed to COVID-19 disruptions than services, but the former accounts for only about 25% of core inflation weights. In addition, the limited impact of tariffs increases on inflation suggests COVID-19 impact could be limited too, since both raise prices mainly through global supply chain disruptions.

• Workers bargaining power remains weak. As a result, should supply shortages drive up inflation, real wages would fall, reducing demand and preventing the development of the wage price spiral required for a sustainable pick-up in inflation.

Fourth, the Fed remains unconcerned by the impact of loose monetary policy on financial stability. In his February 21 speech, Vice Chair Clarida argued that while “optimal monetary policy will (almost) always be correlated with asset prices, […] correlation is not evidence of causation”.

Chart 2: Fed Funds and Yield Curve

Source: Macro Hive, FRED

Fifth, “technical policy factors” also suggest an early cut. The 3mx10year spread, which the Fed sees as the stronger indicator of recessions, has turned negative since early February. The Fed’s 2019 insurance cuts came about once the 3mx10year spread fell through 0 (Chart 2). In addition, the 2019 “insurance cuts” are in line with Williams’ preference for proactive easing when policy ammunitions are limited, which suggests proactivity this time around too. The Fed challenge will be to ease without creating a market panic. One way of doing so would be start with an early, risk management 25bp cut at the March meeting.

The Bottom Line

Based on US economic developments alone, I would not expect a cut at the March FOMC meeting. However, China’s central role in the global economy implies that the Connally doctrine is no longer valid: the global spillbacks to the US from Fed policy changes have become so important that the Fed now has to take them into account. That is why I see a cut at the March meeting as more likely than not.