Commentary / World

The Fed's barrage faces some obstacles to success

by Mohamed A. El-Erian

Bloomberg

The Sunday night action taken by six central banks will be looked back on as one of the biggest, multifaceted and coordinated monetary policy interventions in history. Its immediate aim is to avoid what was feared to be a messy market opening because of the flood of negative coronavirus news during the weekend. The risk is that the firing of so many bazookas at this particular stage ends up not just being premature for economic well-being but also for maintaining financial stability and perhaps for safeguarding the future effectiveness of modern central banking.

The U.S. Federal Reserve’s efforts will dominate the headlines given its status as the world’s most powerful central bank. In a “whatever it takes” policy approach, the Fed slashed interest rates to near zero, announced a $700 billion asset purchase program (quantitative easing) and, through coordination with the five other central banks, an enhancement of dollar-swap lines.

The need for such a huge central bank intervention relates to fear that further downward pressures on asset prices when the markets opened this week would not only fuel unsettling volatility but also create market malfunction, which could cause a negative spillover from the financial sector into the broader economy. It comes on the heels of what I believe is the critical mass reached over the weekend in the sudden-stop dynamics that have been gradually paralyzing the global economy:

More European countries closed their borders, additional businesses and schools were shut down, travel bans were expanded, and some advanced and developing countries effectively imposed countrywide shutdowns. At the same time, more households shifted, either by choice or by government “social distancing” directives, into a hunker-down mentality, with some emptying store shelves first.

To work in sustainably stabilizing markets, this Fed intervention needs to overcome five concerns, which is far from automatic:

First, while helping balance sheets and facilitating favorable mortgage refinancing, such measures will have no effect in restoring economic activity for the time being. Simply put, neither a lower cost loan nor cash in pocket from lower mortgage payments will encourage people to travel and re-engage in economic interactions.

Second, the liquidity injection will help high-quality bonds and perhaps even enhance banks’ willingness to extend credit to minimize the risk of corporate liquidity problems becoming solvency ones. But the effect on other segments of finance, including corporate bonds, is a lot less direct at this stage. This is why I have been arguing for a more urgent laser-focused approach by the Fed to directly address market malfunctions, keeping most general measures for when they will have greater impact.

Third, with the reduction to near zero, the Fed has essentially exhausted the interest-rate mechanism at a time of more limited policy effectiveness because of strained policy transmission mechanisms — or what is likely to be called the risk of a premature firing of a big bazooka. The notion of going negative on rates is undermined by growing evidence from Europe about the risk of counterproductive economic and financial outcomes, as well as concerns about the viability of the money-market sector, especially after the shock of a fund breaking the buck in September 2008.

Fourth, all this complicates the important market challenge the Fed faces of attracting sufficient deep-pocketed buyers back into the stock market. The more such buyers hesitate to engage, the greater the risk that the huge Fed intervention is simply treated as potentially providing a bigger door for trapped longs and other distressed sellers to exit. Should this materialize, markets will trade down ahead of such anticipated selling.

Fifth, to avoid yet another Fed communication mishap, the policy intervention needs to be packaged in a manner that reassures markets that this is part of the path to normalcy. While I hope I am wrong, I worry that the first three press statements posted on Sunday evening do not fulfill this condition yet.

The Fed, having initially contributed inadvertently to the multiyear decoupling of elevated asset prices from more sluggish fundamentals, has just gone “all in” in an attempt not just to preempt market malfunction but also preserve its credibility, standing and, perhaps, political autonomy. It’s a monumental policy bet that I hope works, but I worry that, at least for now, it does not appear to have comforting overwhelming odds of success.

Mohamed A. El-Erian is a Bloomberg Opinion columnist.

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