What to Know About Emergency Interest-Rate Cuts

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Are zero interest rates warranted as an emergency measure? Central banks' mandate is to ensure that the market operates with financial and economic stability--that is, that inflation is kept in check and unemployment is minimized.

So, during moments of market panic when this stability appears to be jeopardized, we should expect the central bank to act. Interest-rate cuts are a key way for central banks to alleviate the pressures on households, companies, and even the government. This can have knock-on consequences on other areas of the market though, including for the banks.

Are there other tactics the Fed can use to promote economic stability? There are other methods for the central banks to inject stimulus into the financial system and promote financial and economic stability, such as:

• Quantitative easing. This is when the government purchases long-term bonds and mortgage-backed securities to spur the economy.
• "Helicopter money." This is a sheer increase in an economy's money supply.

As the market stands, the Federal Reserve recently announced that it will purchase another $700 billion of Treasury bonds and mortgage-backed securities. It also struck a deal with five other central banks in Canada, the United Kingdom, Japan, Switzerland, and the eurozone to lower their rates on currency swaps to keep the financial markets functioning normally.

Are these emergency measures good for investors? They're likely a positive for long-term investors, although that can be hard to see from the eye of the storm. It's natural to get a bit anxious when authorities like the Federal Reserve recognize the challenges in the environment, but in general it's a good thing that central banks are taking proactive steps to address the situation and help the speed and magnitude of the economy.

What is the most effective way to stimulate the economy? A few ways central banks might try to limit contagion or secondary effects include:

• keeping credit available to households and businesses;
• providing liquidity to all market participants;
• maintaining low borrowing costs; and
• trying to limit market financial stress.

But beyond these measures, we actually think the entity that might have the most direct economic impact falls outside the scope of the central banks: fiscal policy.

So, when you consider that the banks don’t directly control the strongest lever of the economy, combined with their mandate, it makes sense that they are going to such lengths to stimulate against a great unknown.

Should I worry about interest rates during this downturn? We at Morningstar Investment Management are broadly looking at two things during this time: risk and opportunity. Here's what that looks like:

• From a risk perspective, we are dealing with the same unknowables that central banks are. We can all hope that the coronavirus will be a historical memory 10 years from now, but we have little idea of what might happen tomorrow or even in three months. That uncertainty is why investors should considering diversifying, keeping costs low, and seeking underpriced assets.
• We also seek opportunity. Right now, market participants are skeptical. Most stocks have fallen; many bonds have risen. This environment means we have an opportunity to do what others can't or won't: to see opportunity amid the madness.

What does that mean exactly? Well, at a minimum, this means calmly seeking to rebalance (an approach that phases the selling of what we believe to be “safer” bonds in favor of buying beaten-down stocks), and if the market panic worsens, search for areas the market might have mispriced on the downside.

A couple of important disclaimers here:

• We can't and won't need to know where the "bottom of the market" is. We believe we can seek long-term profits by simply buying assets for less than they're worth and not panicking when everyone else does.
• "The market" is the culmination of several underlying markets. We take a bottom-up, granular approach to investing, so we will continue to analyze more than 200 asset classes in our search for what we believe to be attractively priced investments.

In times like these, we look to this Warren Buffett quote for perspective and motivation: "Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it's imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do."

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