The Forward Wonk #7: The Fed's Response to Coronavirus
The First In Our Series About The Fed
Welcome to the 7th issue of The Forward Wonk!
Today’s issue will take about 4.5 minutes to read
This is our first issue in our series about the Federal Reserve and Monetary Policy
On Tuesday, I erroneously called my newsletter “The Forward Work” and not “The Forward Wonk”. I’ll learn proper grammar and spelling one of these days…
I’m also 95% sure Substack uses AWS. This edition of The Forward Wonk comes to you from your nearest AWS data center!
I don’t want to waste everyone’s time discussing the history and the basic functions of the Fed — there are plenty of resources covering that. I do think there’s a fundamental misunderstanding of what the Fed does, especially regarding its role in preventing financial crises, and I think that is best remedied by showing examples of what the Fed does. So instead of reciting textbook definitions, I’ll spend the next few Saturdays discussing the following topics:
What the Fed is doing in response to the Coronavirus pandemic
What the Fed did during the 2007/2008 Financial Crisis
The intended and unintended consequences of the Fed’s actions
Did someone forward you this? Subscribe!
Before we start, here are some helpful resources:
No, Fed Chairman Jerome Powell didn’t actually say this, but this is basically what he means whenever he talks
Naturally, it’s important to understand the institutions that help drive the economy when you are discussing economic growth and development. And there’s no discussion about the global economy without mentioning the American central bank — The Federal Reserve. I hope illustrating the Fed’s current and previous actions will allow for everyone to further their understanding of the Fed’s functions and its role in the economy.
If you’re unfamiliar with the Fed is, feel free to read the above links. For now, the most important things to know are
The Fed’s dual mandate: maximum employment and stable prices (keep unemployment and inflation low). Everything the Fed does it to meet this dual mandate.
What monetary policy is: this describes the actions the Fed does to meet its dual mandate.
In Response to COVID-19
The Fed typically controls something called the Federal Funds Rate, the interest rate banks charge each other to borrow money for overnight loans. The Fed controls this rate by buying and selling Treasury securities in markets. Through this, the Fed controls the amount of money being circulated (the money supply) and the interest rate. Because bankers and economists like making things sound complicated, this process is called Open Market Operations. Sometimes the Federal Funds Rate gets pushed to zero percent and the Federal Reserve needs to buy unconventional assets other than Treasury securities to meet their dual mandate. When they do this, it is referred to as Quantitative Easing (QE). QE is pretty controversial among politicians and economists.
It’s early 2020 and you’re the Federal Reserve Chairperson. The economy is humming along and you feel fine, even if there some structural faults you’re worried about. And then out of nowhere a virus emerges and causes a pandemic. Over a few weeks, supply chains and economies shut down and everyone begins to shelter in place. All of a sudden, you’re seeing businesses close, consumption spending and demand drastically decline, and a frenzy in financial markets. As Fed Chair, it’s your job to protect the economy and meet your dual mandate so this is what you do:
March
You announce you’re going to start lending money to the “repo market”. “Repo markets” are the main way banks and other financial institutions get cash, so they’re really important. A large contributor to the 2008 Financial Crisis was the instability of the “repo market”. Basically, banks come here and give up their Treasury securities in exchange for cash. A short while later (usually within 48 hours), the bank pays back the cash, with interest, and receives their security back. The market where all this occurs is referred to as the “repo market”. You commit $1.5 trillion for these loans, with an additional $500 billion each week for the rest of the month.
You cut the Federal Funds Rate, and eventually, you cut it to zero percent.
Announce a new QE program that commits $80 billion to immediately purchase assets and commits at least $700 to further purchases. This eventually is expanded.
Allow banks to use their reserves to lend to businesses and individuals affected by COVID-19. For some smaller banks, the reserve requirement was waived.
Coordinate with England, Japan, Canada, Switzerland, the European Union, Australia, Brazil, Denmark, Mexico, New Zealand, Singapore, Korea, and Sweden to lower the prices on U.S. dollar liquidity swaps in an attempt to improve the liquidity of US dollars. This makes it cheaper for other countries to get US dollars for their banks.
You create a Commerical Paper Funding Facility (CPFF). No, a CPFF does not invest in paper mills or paper manufacturers (as I originally thought), but rather it buys short-term debt securities issued by companies. Companies usually issue these securities to help meet payroll and other short-term liabilities. You later expand it.
You also create a Primary Dealer Credit Facility (PDCF) which gives loans to large Treasury security brokers in exchange for collateral. The Fed did this in March 2008 as well. You do the same for mutual funds through a Money Market Mutual Fund Liquidity Facility (MMLF). You also expand this (yes not that surprising, I know).
You establish both a Primary Market Corporate Credit Facility (PMCCF) and a Secondary Market Corporate Credit Facility (SMCCF) as well as reviving the Term Asset-Backed Securities Loan Facility (TALF). These all aim to provide large employers with credit. Guess what? You expand this later too.
You re-establish the Foreign and International Monetary Authority (FIMA) facility to give repo loans to foreign banks.
April
You start implementing the CARES Act by first reducing the community bank leverage ratio. This frees up money for the banks to lend out.
You establish the Paycheck Protection Program Liquidity Facility (PPPFL) to purchase loans from lenders, which you later expand.
You establish the Main Street Business Lending Program (which, surprisingly, doesn’t have an acronym) to purchase $600 billion of debt from companies with fewer than 10,000 employees, which you later expand.
To help states and cities, you establish the Municipal Liquidity Facility (also, no acronym) that will purchase $500 billion of debt, which you later (guess what?) expand.
May
You state that participation in Fed lending programs will not negatively affect a bank’s liquidity requirements to help them continue lending.
Continue implementation of the above programs and transparency measures.
If you got bored or didn’t follow, that’s okay. The section below is more important than these operational details.
So the Fed’s done some wizardry and created many, many acronyms to lend out money. While it isn’t important to know every detail, it is important to understand the spirit and intentions of their actions. All of the Fed’s actions can be broken down into these five categories:
Lowering Interest Rates & Encouraging Lending
The Fed moved to reduce regulatory requirements to increase lending done by banks.
The Fed reduced rates to reduce the cost of lending in an attempt to encourage customers to continue pursuing loans.
By encouraging lending, the Fed hopes that money flows to people and businesses that need it.
Minimizing International Pressures
By coordinating with other central banks, the Fed is making US dollars more available to foreign banks. This ensures the entire global financial system has access to valuable dollars.
The Fed commits to an international “repo market” to help overall global financial health.
Supporting Domestic Businesses
Through the PPPFL, Main Street Business Lending Program, PMCCF, SMCCF, TALF, and CPFF (I wonder who comes up with these names) the Fed is committing its support and lending capabilities to both small and large businesses
Supporting Cities and States
The Fed didn’t do this in 2008, but they’re directly lending money to state, county, and city governments to help now. Not all cities and counties qualify, however.
Ensuring Financial Market Strength
In a crisis, people become worried, start holding money, and shy away from risk. When this happens, liquidity dries up and markets begin collapsing, threatening to bring the economy down as well. The Fed moved to ensure the stability of markets through QE and lending programs.
Remember, the Fed is an independent institution that can only act through financial markets. The Fed cannot directly give people money or force Congress to adopt new policy. It’s natural to think that the Fed only cares about bankers and hedge funds (and that is somewhat true) but the Fed tries to do as much as it can within its statutory power. Although the Fed can take powerful action, it’s also limited in where it can apply that power.
We can see the Fed evolving and experimenting with non-traditional interventions, as seen through their lending to local and state governments. As Congress continues to fail to enact (what the Fed thinks is) adequate policy, expect the Fed to continue to evolve its action. With the coronavirus induced recession expected to linger, the Fed will continue acting to stabilize the economy.
With these actions, there are many intended and unintended consequences. Today is just about what the Fed did, but after we discuss the Fed’s response during the 2008 Financial Crisis, we’ll dive deep into the consequences.
Closing Time
The Fed plays a vital role in our economy, especially during an economic crisis. In times like this, it plays an important role in minimizing the effects of an economic downturn and all the downstream effects on people. As always, feel free to reply if you have any questions, comments, or concerns. In the meantime, here’s what I’ve been reading:
Boris Johnson says 3m people in Hong Kong will get path to British citizenship (The Telegraph)
Six Randomized Evaluations of Microcredit: Introduction and Further Steps (Abhijit Banerjee, Dean Karlan, and Jonathan Zinman)
The Black American Amputation Epidemic (ProPublica)
And Vik’s crossword:
Have a great weekend. See you all on Tuesday,
Visakh
Crossword Answers:
ACROSS:
1. OPEC
5. DEMON
7. DRAMA
8. SUITS
9. LEA
DOWN:
1. ODDS
2. PERU
3. EMAIL
4. COMTE
9. NASA