The Fed Used Its Bazooka. Now It’s the Government’s Turn

(Bloomberg Opinion) -- The Federal Reserve moved aggressively Sunday. There were three major steps: 1) Easing monetary policy sharply by taking the Fed’s federal funds rate target back to roughly zero; 2) making its conventional liquidity facilities more attractive by cutting the spread over the federal funds rate, and extending maturities for the Fed’s discount window and its foreign-exchange swap program with major foreign central banks; and 3) announcing a new program of quantitative easing, with the commitment to buy $500 billion of U.S. Treasury securities and $200 billion of agency mortgage-backed securities. 

This was a lot of firepower. Yet the immediate market response was negative, with equities falling sharply Monday. This has caused some to argue that the Fed has blown it by wasting its precious and limited ammunition. 

I don’t see it that way. The Fed is doing what it can and should do to support the availability of credit to households and business. What the Fed is trying to prevent is the type of pernicious feedback loop that we saw during the financial crisis: Impaired market function reduced the availability of credit to worthy borrowers; the contraction in credit intensified the economic downdraft, which increased the stress on markets and financial institutions. The negative feedback loop persisted for more than a year, until financial markets stopped functioning and major financial institutions failed.  

As we saw then, waiting is a bad strategy because it allows these types of feedback loops to gain momentum and force, impairing the availability of credit, hurting confidence and leading to further declines in demand and economic activity. The process just keeps going until things break. 

What’s different this time? The impetus is coming from a large shock to demand because of the spreading coronavirus, not from a fragile and overextended financial system. 

The Fed can do very little about the initial demand shock. The central bank can’t prevent the sharp fall in earnings that will bedevil small and large businesses. The Fed can’t prevent workers’ wage and salary income from falling sharply. All the Fed can do is reduce the cost of credit and use its full powers to support markets and the financial institutions to ensure that the flow of credit will not be unduly impaired. 

To help prevent a severe economic downturn, the Fed needs help from the fiscal side. Only fiscal policy -- government spending and tax cuts-- can replace income, not the Fed. This is why a much larger fiscal response is warranted. Not only should we have paid sick leave and extend the duration of unemployment compensation benefits, but also, as economist Jason Furman has suggested, the U.S. government should disburse checks to households as soon as possible. By supporting household incomes, families will better be able to continue buying essential goods and services, and to keep up with their mortgage, rent and other financial obligations. 

I think this aid should persist until the U.S. economy is clearly recovering. We need to do this to prevent a deep recession and grave damage to small businesses and households.      

What else should the Fed do? First, the Fed should continue to watch for signs of financial stress in areas such as the commercial paper market and the corporate bond and securitization markets. If stress in these markets intensifies, then the Fed should bring back the types of the emergency lending facilities that we saw during the financial crisis. This will require legislation from Congress to indemnify the Fed from losses, ensuring that  the Fed doesn’t inadvertently step over the line into fiscal policy.

Second, the Fed should continue to ease the constraints on banks to lend. This means allowing banks to expand their balance sheets and dip into their liquidity and capital buffers. Most likely, some of the credit that is currently being intermediated outside the banking system will flow back to banks. We have already seen this in the drawdown of credit lines by major companies such as Boeing Co. For banks to support such increased demand for credit, there has to be flexibility in how regulatory ratios are assessed so that banks can respond.     

The coronavirus is a very different event than the financial crisis. It is a large shock to demand and incomes, and the process is moving much more quickly. In contrast, during the financial crisis, demand didn’t fall sharply until financial markets became impaired after the failure of Lehman Brothers. We also must recognize that what the Fed can do is limited. 

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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