The Fed and the World: Policy Implications in Volatile Markets

The Fed has brought down the base rate to a range of 0% to 0.25%, bringing it back to the levels earlier seen during the recession of 2006-07. This coupled with the earlier cut of 0.50% is one of the deepest cuts the Fed has gone-in for in the recent history. The action is a response to arresting the fall in US growth emanating from the primary as well as secondary impact of the corona epidemic which is gradually accelerating in the US as well as Europe.

The FOMC statement reads like this – “The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook. In light of these developments, the Committee decided to lower the target range for the federal funds rate to 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals. This action will help support economic activity, strong labour market conditions, and inflation returning to the Committee’s symmetric 2 percent objective.”

Apart from this pure rate action, the Fed is also going in for asset purchases to the tune of US$ 700 billion. This is split into US treasury notes purchases of US$ 500 billion, and the rest US$ 200 billion of mortgage securities. The objective of this action is to keep the markets liquid so that those who wish to move out of long dated papers and longer-term investments should not find it difficult to do the switch in a volatile market. This would also become the basis for creating a semblance of stability in an otherwise risky and volatile market.

The central banks which joined the Fed for a concerted action are the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. The objective is to enhance the liquidity through U.S. Dollar liquidity swap lines. These swap lines will provide the much-needed liquidity buffer and will help banks and financial institutions to offer credit facilities to consumers and businesses on a continuous basis. This removes any bottlenecks that may choke the credit lines in an uncertain business environment that is emerging.



But these actions have not had any visible impact on the markets. What could probably be the reason for this? The markets often viewed such actions as a confirmation of their readings about the current situation that it is quite bad. It is this indirect or implied confirmation that leads markets to further fall after such cuts or actions. But that may not be the case as time passes by, the rate actions and liquidity measures will have a positive impact on investors. This positive impact comes from two factors – one, the comfort that the monetary authorities are watching the situation and that they would take appropriate action as and when required, a second factor is that, the cost of holding the positions or the carrying cost comes down with a fall in interests rates. When asset prices fall at a rapid pace and to lower levels not exactly justified by the longer-term fundamentals, these types of measures would help instill greater confidence in investors and therefore, markets.


The RBI has been following an accommodative policy for a long time and cut the base rate or the repo rate many times in the past. The central bank also has been infusing liquidity into the system through long term repos. A concession on the cash reserve ratio is also offered to banks on their incremental lending to specified sectors of the economy, with the objective of channelizing credit to sectors which need credit support.

In the press conference yesterday, the RBI reiterated its recent focus on improving transmission by infusing USD as well as INR liquidity. The RBI will be conducting further transactions of USD/INR sell-buy swap and Long-Term Repo Operations (LTRO). These moves will have two critical impacts on the markets, 1) curbing INR volatility and 2) providing the banks with ample cushion to absorb cash requirements related to shocks. We believe the steps are in the right direction, addressing the immediate issues at hand. The confidence instilled in Yes Bank depositors by ensuring safety of their savings, is another positive and would help in strengthening the trust in Indian financial services industry and credibility of its regulators.

Around the time the RBI’s press conference was taking place, some sections of the markets started expecting a policy response from the Indian central bank in line with its global peers. A cut in the rate was expected to be effected to reiterate its growth-oriented stance, and pre-empt the economic impact of the corona virus spread. Instead the RBI adopted a more pragmatic approach of gauging the holistic impact of the health scare, rather than jumping on the rate cut bandwagon. In our opinion this is an ideal move, the rate cut (if required) can be implemented at a more opportune time. In the current environment, wherein trade activity is expected to slump sharply, given the partial lockdowns to contain the contagion, an immediate rate cut may not necessarily have the desired impact.


Coming to the comparative position of the domestic economy with other major economies is that the advanced economies operate at full employment or near full employment levels, whereas the economies like India operate at less than full employment levels. The responsiveness of economies which operate at full employment levels to monetary policy actions is much higher in the order and they give more or less desired results. In economies with less than full employment levels these policies need not necessarily be as effective as it was with the other economies. Say for example, in India, if interest rates are cut successively then the space available for further cuts to signal the economy or influence the macro variables will get reduced. Therefore, reducing rates to zero may not be an option in an economy like India. However. Liquidity measures may be more effective to generate interest in investments


In situations like this the fall will come to a halt when the basic reason for the fall is arrested or extinguished. In the current fall there are two factors which looked prominent. One, the adverse impact which the spread of the epidemic would bring upon the global economy, and two, the feeling that the asset prices were a bit too high and that they needed a correction. This was talked about more in the context of the US economy. The containment of the epidemic is just a matter of time as China has more or less got the upper hand over the epidemic, and it may be contained in other territories too, though it may take another couple of months. The markets would also soon realize that the assets are trading at prices lower than or at least equal to their intrinsic value. It is from this point that the markets could start recovering the lost ground.


The COVID-19 spread has now been declared a global pandemic. The pandemic of this scale is unprecedented in history and the health as well as economic impact is difficult to be quantified at this juncture. The initial response has been to go into a partial lockdown and aim to contain the spread.

In an otherwise weak global growth environment, the health scare has dealt an outsized blow to future growth prospects. Despite weak growth indicators the risk assets managed to hold onto the valuations, expecting the intermittent fiscal and monetary stimuli to trigger a recovery. The multi-layered economic impact, from travel & tourism to factory production, has taken the wind out of the risk asset sales. The equity market valuations, which seemed relatively expensive about a month back, has corrected sharply and entered a territory where it may be termed reasonable or attractive. On a trailing-twelve-month (TTM) basis Nifty 50 PE is trading at a PE of 21 as against the last 10 years average of more than 22; similarly, the Nifty Midcap 50 is trading at a PE of 18 as compared to 10 years average of close to 30.


The rationale of phased investments assumes far greater relevance in circumstances like this. It offers a better mode of deploying the funds in an uncertain market, especially where you feel that the markets are running ahead of the valuations. It is the best approach to allocating funds for long term investments. While this bodes well for equities, one needs to be more cautious in fixed income investments because from very low levels of rates and high liquidity, the most probable move would be towards the upside as the conditions in the economy improve. This calls for caution as it is possible for one to be carried away by the feeling that rates may go down further and that there would be more gains to make from the fall in yields. But this could be a trap. Trust the short end and the mid-sector more for better accruals rather than plain long end products.

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