The Federal Reserve and the COVID-19 CrisisECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Spring 2020

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Readings

I Cecchetti and Schoenholtz: Contagion: Bank Runs andCOVID-19

I Cecchetti and Schoenholtz: COVID-19: What can monetarypolicy do?

I Cecchetti and Schoenholtz: Fed Goes to War: Part 1

I Cecchetti and Schoenholtz: Fed Goes to War: Part 2

I Cecchetti and Schoenholtz: Fed Goes to War: Part 3

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Economic Fallout

I The economic contraction from the Coronavirus pandemic isalmost certainly going to be catastrophic

I We do not yet have good data – lockdown really only startedin US in mid-March, most major series are released at bestmonthly and are somewhat backward-looking

I Still: based on data through mid-March, unemployment rateup about 1 percentage point and industrial production downabout 5 percent

I Weekly unemployment claims unlike anything we have everseen

I About 25 million people have filed for unemploymentI US labor force about 160 millionI If all these stay in the labor force, means US unemployment

rate ≈ 20 percent

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Unemployment Rate

Feb2020 Mar20203.4

3.5

3.6

3.7

3.8

3.9

4.0

4.1

4.2

4.3

4.4

4.5Pe

rcen

tUnemploymentRate

ShadedareasindicateU.S.recessions Source:U.S.BureauofLaborStatistics fred.stlouisfed.org

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Industrial Production

Feb2020 Mar2020103

104

105

106

107

108

109

110Inde

x20

12=10

0IndustrialProductionIndex

Source:BoardofGovernorsoftheFederalReserveSystem(US) fred.stlouisfed.org

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Weekly Unemployment Claims

2020-01-20 2020-02-03 2020-02-17 2020-03-02 2020-03-16 2020-03-30 2020-04-130

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000Num

ber

InitialClaims

Source:U.S.EmploymentandTrainingAdministration fred.stlouisfed.org

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Financial Fallout

I Significant financial upheaval, though signs of recovery in lastcouple of weeks

I S&P 500 lost about 35 percent of its value from mid-Februaryto mid-late-March

I Has since recouped about 27 percent of that; still down morethan 15 percent from pre-Crisis high

I Massive increase in market volatility (VIX), though it has alsocome down

I Significant increase in corporate credit spreads – roughly 200basis points from mid-February to mid-late-March; somerecovery since

I Widening of TED spread (LIBOR minus 3 month Treasury):indicator of interbank credit risk

I Collapse of oil prices

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S&P 500 Index

2020-02-10 2020-02-24 2020-03-09 2020-03-23 2020-04-06 2020-04-202,200

2,400

2,600

2,800

3,000

3,200

3,400In

dex

S&P500

ShadedareasindicateU.S.recessions Source:S&PDowJonesIndicesLLC fred.stlouisfed.org

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Market Volatility: VIX

2020-02-10 2020-02-24 2020-03-09 2020-03-23 2020-04-06 2020-04-2010

20

30

40

50

60

70

80

90In

dex

CBOEVolatilityIndex:VIX

ShadedareasindicateU.S.recessions Source:ChicagoBoardOptionsExchange fred.stlouisfed.org

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Bond Spreads

2020-02-10 2020-02-24 2020-03-09 2020-03-23 2020-04-06 2020-04-202.0

2.5

3.0

3.5

4.0

4.5Pe

rcen

tMoody'sSeasonedBaaCorporateBondYieldRelativetoYieldon10-YearTreasuryConstantMaturity

Source:FederalReserveBankofSt.Louis fred.stlouisfed.org

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TED Spread

2020-02-03 2020-02-10 2020-02-17 2020-02-24 2020-03-02 2020-03-09 2020-03-16 2020-03-23 2020-03-30 2020-04-06 2020-04-130.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6Pe

rcen

tTEDSpread

Source:FederalReserveBankofSt.Louis fred.stlouisfed.org

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Oil Prices (Spot, not Futures)

Feb2020 Mar202025

30

35

40

45

50

55

60DollarsperBarrel

SpotCrudeOilPrice:WestTexasIntermediate(WTI)

Source:FederalReserveBankofSt.Louis fred.stlouisfed.org

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The Fed and Recovery

I The Fed has engaged in drastic, rapid, and controversialactions

I Balance sheet expanded by 50 percent by early-April; likely todouble before end of year

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Structure of Lecture

1. Similarities between dealing with a pandemic and dealing witha bank run (post)

2. What should the Fed do in response to a pandemic (post)

3. What has the Fed done (post 1, post 2, post 3)

4. What will happen (speculative, my opinions)

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Bank RunsI Gary Gorton, Misunderstanding Financial Crises, thinks of

bank runs (in either traditional or more modern forms) asinformation events

I Some piece of bad news leads people to believe financialinstitutions are not sound

I Banks are like black boxes, and asymmetric information is animportant friction: hard to tell which banks hold what, whichones are solvent and which ones aren’t, etc.

I Concerned, depositors and other creditors rush to get out;exacerbated by first mover advantage

I Even if most banks are fine, the threat of some being badtriggers a run

I Left untreated, rush for liquidity threatens solvency of systemas a whole

I Lender of last resort can mitigate the liquidity crisis

I But to really end the run, need to change informationenvironment – restore confidence and convince public thatbanks are fine (“stress tests” of May 2009)

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Pandemic

I In current pandemic, official infection rate is low (roughly1/300)

I Likely many more are infected, but in any event most peopleare not infected

I And even with infection, most people will be fine and recover

I But no one knows who is or isn’t infected, nor whether theyas an individual will develop the most severe symptoms or ifthe health system can handle a surge in demand

I Optimal response is to “run” from economic and socialactivity

I Only way to really restore normal life is to manage theinformation environment – transparent political leadership,adequate test and trace mechanisms, and credible worktowards treatment/vaccine

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What Should Monetary Policy Do?

I Starting point: is COVID-19 a supply or demand shock?I Obviously a mix of bothI My own read: in short-run, it is mostly a massive negative

supply shockI The issue is how do you prevent that from turning into a

persistent slump with very long-lasting aggregate demandconsequences (e.g. long-lasting collapse in financialintermediation)

I Monetary policy (conventional or otherwise) is aboutmanaging aggregate demand

I Monetary policy can (and should) try to offset demand shocks– this is consistent with both aspects of its dual mandate

I It should not try to offset supply shocks – in fact, if anythingit should accommodate them. Trying offset supply threatensprice stability mandate

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Aggregate Demand Shock

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Countering AD Shock with Policy

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Lower policy rate to stimulate demand, stabilize both output and inflation; equivalent to inflation targeting with horizontal AD

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Aggregate Supply Shock

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Policy Conundrum Conditional on Supply Shocks

I If you try to stabilize output after a negative supply shock,this will result in high inflation

I If you try to stabilize inflation, it will result in large outputdecline

I What should you do? Depends on nature of shockI Potential output, Y p, stabilizing inflation and allowing output

to decline is optimal (Divine Coincidence, inflation targeting)I Cost-push, ρ, no easy answers

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COVID-19 in Terms of AD-AS

I I see at least the initial economic consequence of thecoronavirus as being mostly supply

I Government enforced lockdownsI Massive decline in labor supply due to social distancingI Basically, a reduction in Y p

I Fed should not be trying to provide stimulus to combat thisI Early interest rate cuts probably a mistake, at least in hindsightI Had no stimulus effect at a time when stimulus wasn’t even

desirable, and left the Fed with less “space” to cut rates whenstimulus is needed (see Loretta Mester’s dissent)

I But demand is likely to be weak long after worst of publichealth problem is over

I Changed spending habits/fearsI Breakdown of bank-firm-worker-supplier relationshipsI Unavailability of credit due to worsening financial conditions

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What Should the Fed be Doing?

I The Fed wants to promote maximum sustainable employmentand price stability

I Maximum sustainable employment is almost certainly far lowernow than two months ago (supply shock)

I At the same time, deflation is more of a fear than inflation(which looks more like weak demand)

I Deflation is a bigger problem/risk than inflation ⇒ argues forbeing aggressive with policy accommodation

I An important component of achieving this dual mandate ispromoting financial stability

I Most of the Fed’s actions in last six weeks best understood inthis way

I Flood markets with liquidity to support market functioningI Extend credit widely to promote continued relationships;

otherwise little chance of strong recoveryI Substitute for private intermediation where necessary

I Big question is whether the Fed has gone too far

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Supporting Continued Economic Relationships

I As a gross oversimplification, in a nutshell what the Fed hasdone for the last month is say: “Don’t worry, we’ll pay for it”

I What they are trying to avoid is massive business failure,which would trigger massive bank failures, which would . . .

I Recall Bernanke (1983): bank failure in Great Depression wascostly not so much because of resulting decline in moneysupply, but rather because when banks failed information andrelationships were lost

I Especially in a services-based economy, businesses are webs ofrelationships and information – not easily replaceable. Failurewould be very costly

I For any hope of a recovery, have to keep businesses and bankson “life support” so that they’re there when we can go backto some semblance of normal

I But to do this, they need cash – to pay bills, to pay debts, etc.

I Fed is supplying that cash

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Legal Constraints on the Fed

I Fed is designed to be an independent arm of the federalgovernment

I Traditional viewpoint: Fed can expand (or contract) itsbalance sheet (reserves plus currency in circulation) by buyingand selling assets without (at least without much) credit risk– Treasuries and agency-backed debt (e.g. GSE MBSs). Fedcan lend to solvent banks facing a liquidity crisis againstsound collateral

I What the Fed should not do: take on credit risk or lend tonon-financial firms

I Legally, the Fed can only buy Treasuries and agency-backeddebt, though there are work arounds (lending to specialpurpose vehicles, SPVs)

I Because of scope of the crisis, Fed is pushing the envelope onthese dimensions

I Is that good or bad? What are the tradeoffs and potentialconsequences?

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13(3)

I In normal times, Fed only interacts with banks

I But they have special “wartime” powersI Historically, section 13(3) of the Federal Reserve act said: “In

unusual and exigent circumstances, the Board of Governments. . . may authorize any Federal Reserve bank . . . to discountfor any individual, partnership, or corporation notes, drafts,and bills of exchange”

I Basically, they can lend to anyone if conditions warrant it

I In effort to end “too big to fail,” Dodd-Frank limited thisability and changed wording of 13(3)

I Lending facilities have to have broad-based eligibilityI Must have approval and backstop of Treasury

I In practice, new wording doesn’t seem much of a constraint

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Interest Rate Cuts and QE

I The Fed’s first actions were more-or-less traditionalI March 3: cut FFR and discount rates by 50 basis pointsI March 15: cut FFR by 100 basis, down to zero. Cut discount

rate by 150 basis pointsI March 15: also announced new $700 billion QE program: $500

billion in long-term Treasuries and $200 billion in agencymortgage-backed securities

I Interest rate cuts and “traditional” QE (sometimes calledtargeted asset purchases) are designed to stimulate demand

I Not obviously the right moves in the fact of the shock

I Indeed, interest rate cuts actually seemed to stoke fears

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Lender of Last Resort, Market Liquidity, and FinancialStability

I Other actions broadly fall under rubric of serving as lender oflast resort, supplying liquidity in key markets, and promotingfinancial stability

I Challenge is that now 2/3 of credit intermediation happensoutside of traditional banks

I My own opinion – these actions, at least in principle, make alot of sense

I Want to keep cash flowing so that business and banks cansurvive in a state of suspended animation

I If not, with fewer and impaired businesses and banks, nopossibility of economic recovery once public health scare haspassed

I But some of the details of these programs are unprecedentedand move the Fed into risky territory

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Resuscitated Actions and FacilitiesI Repo funding to short-term Treasury markets to promote

market liquidity and functioning in short-term marketsI Dollar swap lines with foreign central banks: basically a way

for foreign central banks to lend in dollars; also used in2007-2009

I Commercial Paper Funding Facility (CPFF): create a SPVthat Fed lends to to purchase commercial paper. Lender oflast resort – commercial paper is short-term and hence“runnable”

I Money Market Liquidity Funding Facility (MMLF): roughlysame idea; lend to institutions to purchase assets of MMFs tomake sure they can meet redemptions without “breaking thebuck”

I Primary Dealer Credit Facility (PDCF): way to lend to primarydealers (the big banks that buy Treasuries, hencemarket-makers) against wide range of collateral to supportmarket liquidity and function

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New Actions and Facilities

I QE infinity: purchases of Treasuries and agency bondswithout limit

I Resuscitation of TALF (facility to buy asset backed securitiesother than mortgages) and small changes to MMLF and CPFF

I Really ground-breaking new stuff started rolling in March 23and continued into this month:

1. Primary Market Corporate Credit Facility (PMCCF): createsSPV that purchases bonds directly from investment-grade firms

2. Secondary Market Corporate Credit Facility (SMCCF): createsSPV that purchases previously issued corporate bonds

3. Municipal Liquidity Facility (MLF): purchase municipal bondsissued by states, cities, and counties

4. Main Street New and Expanded Loan Facilities (MSNLF andMSELF): sets up SPVs to fund 95 percent of loans issued bytraditional banks to small and medium-sized businesses

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ConcernsI With purchases of corporate bonds and effectively making

loans to municipal governments and non-financial businesses,Fed is taking on credit risk

I In a sense, it is engaging in fiscal policy: recall traditionalpurview of central banks is to lend to banks against soundcollateral and only purchase assets with little or no credit risk

I In some sense, Fed has gone from “lender of last resort” to“buyer of last resort”

I On the one hand, this is a natural jump since so muchintermediation is now outside of the banking system (capitalmarkets and securitization)

I On the other hand, involves Fed making distributional choicesand taking on credit risk, both of which are fundamentallyfiscal

I In some cynical sense, the CARES act uses the Fed as anoff-balance-sheet vehicle for the Treasury

I Makes sense in that Fed has expertise and ability to movequickly

I But dangerous precedent for longer-run independence31 / 33

My Own View

I In my view, Cechetti and Schoenholtz are a bit too hard onthe Fed’s “overreach”

I They are operating as lender of last resort applied to modernfinance

I For any recovery to happen, have to keep relationshipsbetween banks-firms-workers-suppliers alive

I This requires tons of cash when economic activity hasotherwise ground to a halt

I With unemployment ≈ 20 percent, now is not a great time toworry about moral hazard and longer-run independence issue

I In a war, you have to act quickly. I don’t trust Congress andthe Treasury to do that effectively. I do trust the Fed

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Going ForwardI No doubt we are in a deep recessionI Big question is what will recovery look like? V-shaped,

U-shaped, or L-shaped?I Fed and Treasury actions today should not be aimed at

stimulating the economy at present, but rather in layingfoundations for recovery

I I am not optimistic about quick recovery – economy is toocomplex, relationships too varied, to just flip a switch. I reallysee No Easy Way Out

I There are also going to be long-run changes in consumptionand living patterns, and consequent effects on particularindustries (e.g. oil and airlines)

I The Fed cannot eliminate the economic damage from thehealth crisis

I What it can and should do is try to eliminate that fromdestroying the financial system, which would have deep andlonger-lasting consequences

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