Today marks the beginning of this week’s data calendar for the US, with the advanced reading of Q1 GDP and the first Federal Reserve meeting since rates were lowered to the zero lower bound in successive inter-meeting announcements in March.
The advanced Q1 GDP reading came in at -4.8%, close to the median forecast supplied to Bloomberg of -4.0%. The decline in first quarter GDP was, in part, due to the response to the spread of COVID-19 as governments issued “stay-at-home” orders in March. The decline in personal consumption expenditures (-5.26%), activity in the services sector (-4.99%) and domestic and fixed investment (-0.96% and -0.43%) were the main drags on the overall GDP figure. Some positive contributions came from net exports (+1.3%) and government spending (+0.13%), although the latter is set to increase in the coming periods. Despite the substantial drop in US economic activity, the reaction in FX markets was muted.
This is arguably due to the fact that the official figure came in close to the median forecast and the fact that this reading is the preliminary GDP figure.
Given the seismic economic shift that took place in Q1, markets are undoubtedly expecting this number to be subject to revisions. In FX markets, the dollar still trades on the back foot ahead of tonight’s Fed announcement.
Chart: US first reading of Q1 GDP comes in at -4.8% but limited market reaction as dollar still trades on the back foot
Fed preview: FOMC to avoid painting themselves into a corner with forward guidance tonight
Since the last scheduled FOMC meeting, economic activity has collapsed due to the implementation of social distancing measures, the labour market has completely unraveled with over 26m net unemployment insurance claims to date, and financial frictions arose in markets. The Fed responded accordingly in a string of inter-meeting interventions where the monetary policy toolkit was pretty much emptied to provide a backstop to the economy, ease funding pressures and improve market functionality. While market conditions have improved since the Fed implemented crisis-era measures, enabling the scaling back of the New York Fed’s repo operations, the current climate doesn’t suggest a significant shift will be forthcoming from the FOMC, especially with the economy still in a state of lockdown.
This has been evident in some of Jerome Powell’s recent commentary
In response to questioning about Yield Curve Control on April 9th, one of the last remaining unused tools in the Fed’s toolbox, Powell responded that “the principal focus now is not on adjusting what we see is quite an appropriate stance of monetary policy, at least for the next few months”. His response suggests that markets shouldn’t expect too many fireworks from tonight’s meeting as the current monetary policy framework allows the Fed to remain flexible to any economic and financial shocks on the horizon. Such shocks are highly likely to arise in the coming months as the global economy begins to exit containment programs and the dust settles on the true economic toll of social distancing measures. A change in the composition of consumer demand is one likely avenue by which the economy is likely to change upon reopening.
In this light, we don’t expect the Federal Reserve to corner itself with any explicit forward guidance on the stance of monetary policy, especially around the size of the Fed’s balance sheet and the implementation of a fixed monthly purchasing framework.
However, we do highlight that the probability of minor tweaks to its Main Street lending facility and technical tweaks to its interest rate corridor is likely. An increase in the IOER (Interest on Overnight Excess Reserves) and a reduction of the reverse repo rate are likely as the effective fed funds rate sits only 5bps above the lower bound. Such tweaks should increase that spread somewhat, in effect increasing the buffer between the market rate and the lower bound of the interest rate channel. This should increase confidence in the Fed’s ability to control interest rates, especially after last year’s breach of the upper bound which kick started the New York Fed’s repo operations for the first time in a decade. However, this isn’t an inevitability. FOMC members may highlight the communication issues surrounding such a move. The last thing the Fed wants right now is for the market to assume they are tightening rates at the margin as opposed to adding additional layers of support to its interest rate channel. For this reason, they may delay such a technical tweak to June’s meeting.
Chart: Fed may opt to increase IOER rate and lower reverse repo rate to protect the lower bound
With respect to the Main Street program…
The Federal Reserve has been under pressure from several key trade groups and lawmakers to open up the access criteria to its $600bn emergency loan pool. Currently, the Fed is relying on banks to operate the program, issuing four-year loans to businesses that have at most 10,000 employees or $2.5bn in revenue in 2019. The Fed will then buy 95% of the loan, reducing the credit risk for the participating bank. However, the minimum loan amount is $1m, while many stakeholders have raised concerns that this is too large of a requirement for SME’s, which the program is targeting, to commit to. Not only could the minimum loan requirement be lowered, but the rate also. Currently, the proposed interest rate sits at a spread of 250-400 basis points over the secured overnight financing rate of 0.01%, however, such a high rate on a sizeable loan would restrict many businesses.