Fed seen cutting rates amid virus threat, low inflation

SAN FRANCISCO/MEXICO CITY (Reuters) – The Federal Reserve may need to move aggressively to cut borrowing costs to cushion the economy from the effects of the rapid spread of the new coronavirus, which sent global stocks tumbling this week.

Traders of futures contracts tied to the U.S. central bank’s policy rate are already betting on it. On Thursday they were pricing in about a 76% chance of the Fed starting to cut rates as soon as next month and trimming an extraordinary three-fourths of a percentage point by September, according to CME Group’s FedWatch.

That would bring the short-term target rate to below 1% for the first time since 2017.

Traders saw just a 33% chance of a March rate cut on Wednesday. But that was before a report showing new cases in Iran, Italy and elsewhere were growing faster than in the outbreak’s epicenter of China, and leaders around the world began rallying their nations to prepare for a broader epidemic.

In the face of a potential economic slowdown as governments shut schools, cancel sporting events and restrict travel, global central bankers have for the most part taken a wait-and-see approach.

European Central Bank President Christine Lagarde said on Thursday that she would need to see a “long-lasting” shock to act, adding that it has “certainly” not gotten to that point yet. In South Korea, home to one of the biggest outbreaks outside of China, the central bank unexpectedly held its fire on rate cuts.

Unlike many other central banks, the Fed still has some room to cut interest rates, although officials there have said that they want to see a “material change” in the economic data before they take further action after cutting rates three times last year.

At the same time, though, they have warned that with inflation already low, any response to an economic shock may need to be supercharged to have an effect.

On Thursday Chicago Fed President Charles Evans told a central banking conference in Mexico City that with limited room to cut interest rates and a downward pull on inflation, “policymakers must commit to provide extraordinary accommodation in order to meet their mandate.”

Asked about the impact of the coronavirus directly, Evans said the Fed is paying “close attention,” although he reiterated what appears to be the consensus view at the Fed: that the effect on the economy will be transitory.

VIRUS ALREADY HURTING COMPANIES

Some major U.S. corporations say the virus is already weakening their balance sheets and hitting earnings.

Best Buy Co Inc (BBY.N) on Thursday lowered its forecast for annual profits, citing a slowdown in manufacturing by electronics companies. Apple last week warned it could miss revenue targets for the first quarter of 2020 because production in manufacturing sites in China was lower than expected, limiting global iPhone supplies.

And World Health Organization officials were holding talks with officials of the 2020 Olympics, scheduled for July in Tokyo, although no decision was expected soon. Their cancellation or relocation would be a massive blow for Japan, the world’s third-largest economy, which closed its entire school system for the next month in a bid to prevent spread of the virus.

Wall Street’s three main indexes ended Thursday trading on track for their steepest weekly pullback since the global financial crisis, with the S&P 500 .SPX registering its biggest one-day loss in percentage terms since August 2011. The yield on the benchmark U.S. 10-year Treasury US10YT=RR touched a record low of 1.2408%.

“The Fed’s desire to be data-dependent may capitulate to market sentiment,” said Jon Hill, an interest rates strategist at BMO Capital Markets.

Worries about the spread of the coronavirus have also contributed to a drop in inflation expectations, a trend policymakers are battling out of concern that low rates leave them with less ammunition to counter the next downturn. Fed Vice Chair Richard Clarida said on Tuesday that inflation expectations were “at the low end of a range I consider consistent with our price-stability mandate.”

(GRAPHIC: The 5-year, 5-year foward breakeven inflation rate – here)

That could get worse if the new coronavirus continues to spread, predicted JPMorgan’s chief U.S. economist Michael Feroli, in part because a decline in oil prices due to reduced global demand could feed into lower prices for U.S. goods and services.

The flu-like illness caused by the new coronavirus, which originated in China but is now spreading faster in other countries, has killed 2,800 and infected about 80,000.

U.S. President Donald Trump on Wednesday appointed Vice President Mike Pence to head public health efforts to contain the virus’ spread.

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