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Why largest Fed rate cut in a decade may not be enough to stop coronavirus market plunge

Expert explains markets' coronavirus dip
Expert explains markets' coronavirus dip 03:05

When the Federal Reserve cuts interest rates, the stock market usually goes up. But the novel coronavirus appears to have contaminated the rules on Wall Street along with much of the planet. 

The Fed on Tuesday lowered its short-term interest rates by 0.5 percentage points in an emergency move aimed at protecting the economy against the disease known as COVID-19. That was the biggest single cut in the Fed's benchmark interest rate since October 2008 at the start of the financial crisis.

And yet, the market plunged. The Dow dropped 750 points on Tuesday, on top of what has mostly been a pretty terrible two weeks for stocks. The broader S&P 500 stock index was down 2.8% and the tech-heavy Nasdaq dropped nearly 3%.

The market did rebound some Wednesday morning, although pundits are attributing the day's rally to growing odds that Joe Biden will be the Democratic nominee after Super Tuesday voting results. Many market watchers are still scratching their heads, wondering if the Fed can ever cut rates enough to protect the economy from pandemic — and even if the Fed made a mistake with its dramatic rate-lowering move. 

"I think that was a waste," said Robert Eisenbeis, a vice chairman of the investment firm Cumberland Advisors and a former top Fed economist. "People are looking right beyond this cut to what happens next — and there is a lot of uncertainty."

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So what happened? Some think the Fed acted too fast, while some think the Fed had no choice. 

"If the Fed hadn't cut interest rates, the market would have been down even more," said Jim Bianco, a top Wall Street strategist who heads his own independent research firm. "We are headed for a massive economic disruption, and if the Fed doesn't do something, March will end up being when the recession started."

The biggest issue is that the market hates uncertainty, as the old saying goes. And the coronavirus itself is a massive unknown — as is its potential impact the economy. But that's just one likely explanation. Here are three more reasons why investors didn't react well to the Fed's medicine on Tuesday.

1. Maybe the Fed made the market panic worse

What has helped drive up stocks the past few years is something market watchers call FOMO, or "fear of missing out." Now the market seems to be sliding because of a new fear — that Fed officials may know something scary the rest of us don't.

The Dow rebounded by more than 1,000 points on Monday and was up on Tuesday morning. But within 20 minutes after the Fed announced its rate cut, stocks were headed down. The central bank typically cuts or raises interest rates at regularly scheduled meetings. It also usually cuts only a quarter of a percentage point. The Fed didn't stick to any of those habits.

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That happens rarely, and typically only when the Fed is trying to head off a bad economic fall. When it's clear that is about to happen, a Fed rate cut can calm investors and boost businesses and the broader economy. 

But when investors are not yet fretting that the economy is headed for trouble, a big surprise Fed move like the one Tuesday can create more fear, not less. And since the Fed often says it is "data dependent," some investors may be wondering what data the Fed may have seen that caused policy makers to opt for an emergency rate cut. 

"The Fed acting made investors' worries more real," said Tim Duy, a noted Fed watcher and economics professor at the University of Oregon.

2. Maybe lower interest rates won't work this time

There are a number of reasons why lower rates tend to lift stocks. But the simplest has to do with lending. When interest rates drop, it's cheaper to borrow money. When it's cheaper to borrow, people and business tend to take out more loans. They spend and invest some of that money, which drives economic growth.

What's not clear is that this standard monetary remedy is the right cure for an epidemic-induced economic downturn, according to David Kelly, chief global strategist at JPMorgan Asset Management. 

One reason is that a coronavirus-led decline could be particularly hard on service sector companies, like restaurants and stores, as opposed to construction firms and factories. The latter are typically the types of businesses that borrow a lot and would benefit the most from lower interest rates. But even for manufacturers, it's not clear how much the lower interest rates could help, Kelly wrote in a note to clients.

Expert predicts effects of coronavirus 06:20

"Many years of very low interest rates suggest that there is very little economic activity that is being held in check by financing costs anyway," Kelly said.

Fed Chairman Jerome Powell declined to say at a brief press conference following the rate cut news whether he thought other stimulative measures, like a tax cut or major federal spending on health care materials and infrastructure, would do a better job of rescuing the economy from a recession.

But if the coronavirus turns Americans into a nation of shut-ins for a prolonged period of time, even tax cuts won't help that much.

"Economic theory doesn't tell you what to do," former Fed economist Eisenbeis said. "This is what uncertainty is about."

3. Maybe coronavirus might spread inflation

There's still a possibility that the coronavirus outbreak might not turn out to be as bad as it is appears. But some market watchers said the Fed slashing interest rates may be stoking a new investor concern: inflation. 

The number of coronavirus cases appears to be dropping in China. If the outbreak turns out not to be a pandemic, the economy is likely to snap back in short order. And if the Fed doesn't move quickly to raise interest rates, then the pent-up demand is likely to drive a sharp increase in economic activity — driving up prices and otherwise fueling inflation.

Even if that doesn't happen, more inflation in the wake of the coronavirus is likely headed our way, if only because the combination of more people shut in and spending and fewer people outside and working could stoke demand for goods and lead to rising prices. 

Even if the coronavirus outbreak ends up being not all that bad, meanwhile, it will likely change corporate behavior. More companies may not be comfortable relying on China or other countries for their supply chains. If more manufacturing comes back to America, that likely will increase the costs of production and boost prices. 

"The best case is that the virus will go away, but it will still have lasting implications," Bianco said. "There will be less globalism and more inflation."

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The University of Oregon's Duy said that while Tuesday's stock drop will lead many people to conclude that the Fed messed up, it might not mean that at all. There is an adage on Wall Street: Buy on the rumor, sell on the news. In other words, the stock market jumped on Monday on the rumor that the Fed was set to lower interest rates, and it dropped on Tuesday when the bank delivered the cut.

And that's all we may be seeing — not investors carefully making a call on whether a rate cut was needed or not. What's more, stock movements increasingly are propelled by momentum following computerized trading that buys and sells millions of shares in mere seconds. That may increase how much stocks rise and fall, but it may not make those moves any more meaningful. 

"It's dangerous to try to get too inside the mind of traders," Duy said. "It could be nothing more than positioning. The pressure to sell is quite large right now."

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