March Minutes Offer Window into Fed's Thinking

The Federal Reserve on Wednesday released the minutes from its two emergency meetings in March. Readers will recall that the Fed cut interest rates twice in the month, first on March 3 by 50 basis points and then on March 15 by 100bps. In addition, it unleashed a slew of liquidity programs to help ensure proper functioning of financial markets amid the Covid-19 stress. While the minutes might feel like old news, these are something of a window into how the Fed is thinking and what might come next. Here are my thoughts. Things Were Bad Then; They Are Worse Now Reading through the Participants' Views on Current Conditions and the Economic Outlook is something of a reminder of how uncertain things were three weeks ago, but also it's a reminder of how much worse they are now. In the March 15 discussion, there are observations like the pandemic was starting to impair consumer confidence and pullbacks in purchases at retail stores, except for emergency buying, had reportedly intensified significantly and Many U.S. businesses had moves to telework arrangements. Speaking purely in terms of economic effect, all of these are now much worse. Is the Pandemic Inflationary? I hear a lot of people trying to make an inflationary argument about this pandemic, mainly by claiming that aggregate supply should be contracting. The Fed doesn't see it this way. The participants remarked that a stronger dollar, weaker demand, and lower oil prices were factors likely to put downward pressure on inflation in the period ahead and observed that this meant that the return of inflation to the committee's 2% longer-run objective would likely be further delayed. There did not appear to be any debate around this conclusion. The Fed Can't Save the Economy Participants stressed that measure taken in the areas of health care policy and fiscal policy, together with actions by the private sector, would be important in shaping the timing and speed of the U.S. economy's return to normal conditions. This is an unusually blunt statement for the Fed to include in its minutes. In other circumstances, they would view this as either too overtly political or else painting monetary policy as impotent. In this case it was so painfully obvious that the Fed didn't bother to mask its real thoughts in more obfuscated language. The very next sentence tells you everything you need to know about why it acted. Participants agreed that the Federal Reserve's efforts to relieve stress in financial markets would help limit downside near-term outcomes by supporting credit flows to households and businesses, and that a more accommodative monetary policy stance would provide support to economic activity beyond the near term. So the Fed's goals are twofold. First, it wants to make sure the financial system functions well, banks plenty of liquid, and so on. This avoids what should be a deep, but short, recession becoming something much longer. Then it keeps interest rates very low, such that once the recovery begins, it is as powerful as it possibly can be. I should also note that the Fed actively wants to avoid negative rates. It is a small thing, but the Fed was expressly worried about rates turning negative. A few participants also remarked that lowering the target range to the ELB (remember, this is the effective lower bound, or 0%) could increase the likelihood that some market interest rates would turn negative, or foster investor expectations of negative policy rates. Such expectations would run counter to participants' previously expressed views that they would prefer to use other monetary policy tools to provide further accommodation at the ELB. In this section it shows the Fed is so worried about the side effects of negative rates that it doesn't even want to create the impression that such a policy is even under consideration. Municipals Are on the Fed's Mind The one market that seems to be continuously dislocated, but hasn't yet received direct support, is municipals. While the whole bond market remains much less liquid than was the case in February, away from municipals, trading flows have improved substantially. Given how central the state and local governments are to addressing the public health crisis, not to mention muni issuers like non-profit hospitals and nursing homes, it is surprising the Fed hasn't done something directly to help munis. But this market is on their minds. In each section where financial market stress is mentioned, municipals are part of the discussion. We will see if the Fed eventually starts buying bonds in this market, or if there is fiscal intervention to help with local government finances. So, What Comes Next? Beyond the possibility of a program for municipals, these minutes show the Fed is very focused on financial market functioning. The fact that in the ensuing week it rolled out a number of other liquidity tools backs up the idea that liquidity is the priority. It isn't that the Fed doesn't care about stimulating the real economy, but it knows there isn't much it can do until the public health crisis has passed. In terms of trading, that tells me that buying bonds (or even stocks) where the bet is mostly that the market will continue to function well are safe trades. Betting on a quick economic recovery is much riskier. The Fed isn't bailing you out of that trade. In the debt world, I think that makes investment-grade corporates the best play, and high-yield corporates a good deal riskier without offering much more upside.

March Minutes Offer Window into Fed's Thinking

Is there a fear of inflation? Is there a chance to go negative? What's next? Here's what we can conclude from the body's own words.

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