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Surprise cuts necessary, but not sufficient

GH web 18 v2
George Henderson | Posted on Mar 4, 2020

Key Points

  • Overnight, the US Federal Reserve executed an out-of-cycle 50 basis point cut as financial conditions have deteriorated sharply over the last week.
  • The closed circuit of declining confidence driving lower risk appetite, leading to increased financial stress and back to declining confidence, can be broken by government fiscal policy and monetary policy stimulus.
  • We expect a concerted global effort across governments and central banks to support economic growth. New Zealand will be part of that effort.

What will this achieve?

Financial conditions have deteriorated sharply over the last week. The US S&P index fell 15.8% from the record highs seen in February, though a bounce now leaves it down 11.5%. Borrowing costs of lower quality loans in the US have risen by 0.8%.

 Picture2
Source: Bloomberg

Cuts in interest rates will obviously have no effect on the public’s health. However, there are large economic uncertainties that the supportive action by governments and central banks can partially mitigate.

A lack of confidence poses an imminent risk. 

Specifically, sharp declines in consumer and business activity, as individuals are either forced to quarantine or choose to do this themselves, has occurred in China and is a likely outcome in other regions. This reaction, accompanied by a lack of business and market confidence, reduces activity and creates financial stress, leading to increased defaults and bankruptcies. Unnerved markets, in anticipation of this stress, can exacerbate this situation by reducing lending and increasing interest rates. This closed circuit of declining confidence driving lower risk appetite, leading to increased financial stress and back to declining confidence, can be broken by government fiscal policy and monetary policy stimulus.

Are interest rates the right tool? 

There is an argument that lower interest rates are not appropriate in this environment and other means of support are needed. This is partially correct but, to the extent that lower interest rates can dampen some of the negative consequences, they are useful. Furthermore, failure to lower interest rates runs the risk of further stoking the fear in markets as the chances of economic recovery diminish. From the central bank’s standpoint, the economic shock will be exacerbated if confidence deteriorates, so any support they can offer will reduce negative outcomes and help them reach their inflation targets.

What do we expect in New Zealand?

We expect a concerted global effort across governments and central banks to support economic growth. New Zealand will be part of that effort. From the Government, we are already seeing support packages being drawn up; from the Reserve Bank of New Zealand we expect rate cuts. While there is uncertainty over the size of any moves, we currently expect the Official Cash Rate (OCR) to be reduced from 1.0% to 0.5%. Timing is also uncertain, but most likely is a cut at the March OCR review.

What are we monitoring? 

The scientific communities understanding of COVID-19 is developing fast and we monitor this closely. Economic scenarios vary widely and are very dependent on consumer behaviour and confidence. Valuation declines in risk assets, as investors become unwilling to accept risk, can be self-fulfilling and we look to see if the circuit breakers of fiscal stimulus and interest rate cuts are effective. We also are assessing if valuations capture a scenario of widespread infection rates (typical of those of the seasonal flu) as this outcome is appearing increasingly likely.

 

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