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Monetary Policy Response to COVID-19

While Congress and the White House debate fiscal policy measures, the Federal Reserve has made a flurry of monetary policy announcements over the past week. Below is a summary of what is happening and what the Fed's actions mean.

Trading in government securities (such as US Treasury bonds and Agency Mortgage-Backed Securities) has become  relatively illiquid in the past several weeks. The reason this matters is that much of our financial world relies on these assets and markets, from our banking system to insurance companies, pensions, mortgages,  money market funds, and so on. These markets are an important part of the “plumbing” of the US and global economy.

To address liquidity issues, the Federal Reserve announced last week that it would dramatically expand repurchases (repos), which allow financial institutions to borrow dollars if they post government securities as collateral. It is essentially swapping one government security (such a Treasury bond) for another (US dollars). The best analogy we have heard is that repos are like the change machines at an arcade; it does not matter how many $20 bills you have if the machines only accept quarters. Similarly, it doesn’t matter how good a balance sheet is if some of the assets are not dollars. Expanding repos is the Fed’s attempt to provide cash to financial institutions that own (less liquid than cash) government-backed bonds. Understanding the size of the program is best illustrated by a quote we read last week: “The Fed just brought an aircraft carrier to a knife fight.”

The Fed was scheduled to meet (on Tuesday and Wednesday of) this week, but held the meeting (secretly via teleconference) on Sunday and concluded with a surprise announcement and press conference. The major announcements were:

  • A 100 basis point (1%) cut to the target federal funds rate
  • A new round of Quantitative Easing (QE 4), of up to $500B in Treasury bonds and $200B of Agency MBS
  • Swap lines to ensure US dollars would be available to major trading partners
  • Elimination of reserve requirements for banks and an encouragement that the banks use the discount window

While the rate cut marginally decreases borrowing costs for businesses and consumers, the other announcements are likely much more consequential. While it remains to be seen if liquidity in Treasury trading improves, the QE announcement immediately bolstered MBS prices (and brought their concerning spreads down). Additionally, the swap lines and and banking news were meant to bolster the banking system and signal that although we may have health and economic problems, we will not have banking problems to worry about too. It seems that Fed is applying the lessons of 2007-2009, mainly that acting early and overwhelmingly is the best approach in a crisis.

These monetary policy actions are necessary, but not sufficient. The Fed saw some anomalies in the economy’s plumbing system and decided to act. If your house is on fire, a functioning plumbing system will not save your house. However, a dysfunctional plumbing system or fire hydrant could doom it.

The health and economic challenges that we face can only be solved with fiscal policy. As spending grinds to halt, businesses will find it difficult (or impossible) to pay their employees, vendors, rents, and then those businesses will not be able to pay their people and expenses, and so on. It does not matter if rates are higher or lower because nobody will be borrowing in the first place. The Fed has done what it can, but the economy really needs the federal government to step in and spend whatever is needed to get us through this health crisis. Hopefully, the fiscal authorities (The White House and Congress) can pass something soon.