Paper: US Monetary Policy During Corona

By Mo Fakhro

The Federal Reserve acted quickly and effectively to reduce the negative economic impact of the coronavirus pandemic, and helped to alleviate a great deal of financial suffering.  It did this through a combination of lowering the federal funds rate (the rate at which banks lend to one another), directly buying Mortgage-Backed Securities to lower long term interest rates, providing additional liquidity to stabilize markets, and directly supporting small and medium sized businesses with loans.  The expansionary monetary policy of the Federal Reserve was not the only major policy of the US Government.  It was also coupled with an expansionary fiscal policy, that was headed by the US Treasury and US Congress.  The quick actions of the Fed compared to Congress, demonstrated the usefulness of the Fed as a relatively unbiased, independent entity, that can act quickly.  While the actions of the Federal Reserve were much needed, and had a positive net impact, they helped to contribute to what some perceive as an asset bubble in the stock market, that could have future negative consequences.  They also may have had the net result of providing too much credit to uncreditworthy companies, which may lead to an increase in defaults in the future.

Among the actions that the Federal Reserve took when the pandemic started to take its toll on the US economy was to lower the Federal Funds rate to almost zero ⁽¹⁾.  The Federal Funds rate, despite its unusual name, refers to the rate at which banks borrow from one another.  In some countries it is referred to as the interbank lending rate.  The Federal Reserve influences this rate by increasing or decreasing the money supply.  It typically does this through what are referred to as open market operations, which involves either the purchase of government bonds onto its balance sheet, or the sale of government bonds.  An expansionary monetary policy involves the purchase of government bonds.  This has the effect of increasing the money supply, because it puts money into the hands of the sellers of the bonds.  This in turn reduces the Federal Funds rate, which in turn reduces the cost of borrowing across the economy.  As more money becomes available to banks, and as they rush to lend out those funds to their customers, this increase in the supply of money will cause the interest rate across many parts of the banking system to drop.

Between March and June of 2020, the Fed significantly increased its purchases of US Treasury Securities and Mortgage-Backed Securities.  According to the Board of Governors of the Federal Reserve System, the Fed’s holdings of securities increased from around 4 Trillion US Dollars to 7 Trillion US Dollars ⁽¹⁾.  These additional holdings of securities had the effect of adding an additional 3 Trillion US Dollars of cash into the system.  When the effects of the money multiplier are included, the additional dollars in the system that were deposited into banks were amplified by upto ten times.  This would have provided banks with additional deposits and reserves, which would have put pressure on them to lend out the new funds to businesses.  As a result, businesses would have been better able to attain loans from banks.  This in fact appears to have been the case.  The actions of the Fed to purchase securities had the additional benefit of stabilizing the markets during a critical period of uncertainty.  This helped to reduce volatility in the markets, which would have created a sense of panic, that may have had a ripple effect to other parts of the economy.  The quick actions of the Fed ensured that markets flowed smoothly by providing liquidity ⁽²⁾. 

In addition to this, a lending program was launched to support businesses, called the Mainstreet Lending Program ⁽²⁾.  This program allows loans to be given to small and medium sized organizations, in order to help them to meet their working capital obligations.  It was coupled with another program named the Payroll Protection Program, which, as the name suggests, protected employee wages, thereby reducing the need to lay people off.  These two programs require the approval of the US treasury, and are referred to as “13(3)” actions because they are derived from that part of the laws that govern the Federal Reserve.  The Fed also took the step of directly buying the bonds of companies, as well as buying shares in exchange traded funds that focus on corporate bonds ⁽²⁾.  This had the effect of increasing the liquidity for bonds and reducing the interest rate. This program of quantitative easing, allowed the Fed to ensure the free flow of funds, and further ensured that the increases in money supply made their way across the economy. 

The additional liquidity has provided a lifeline to companies during a very challenging period.  The overall impact of these measures by the Federal Reserve has helped to ensure that liquidity is available for companies to borrow money at low interest rates.  It has thus allowed companies of different sizes to remain afloat during a period of severe negative cash flows in certain segments.  The additional supply of money though, does bring with it the risk of artificially inflating the value of assets and instigating future loan defaults.  Some have drawn attention to the fact that, while the expansionary monetary policy of the Federal Reserve during the coronavirus pandemic did not cause significant consumer price inflation, it does appear to have caused asset price inflation ⁽³⁾.  They further argue that the Fed measure of inflation should include asset inflation, not just consumer price inflation.  By that measure it is noteworthy, that prices have in fact inflated in areas such as housing and publicly traded shares during periods of expansionary monetary policy.  Others have noted that even sectors with a bad credit history, such as airlines, have an abundance of credit available today ⁽⁴⁾.  While this is desirable from an economic and social perspective, because it supports vital infrastructure, it does highlight the risk that cheap and abundant credit may lead to loans being given to entities that may have trouble paying them back.  The airline industry has historically not been a good sector for lending.  This is because of high levels of competition, and the cyclical nature of revenue (seasonal travel), coupled with high fixed costs (the planes), and unpredictable and often erratic variable costs (fuel prices), have meant that loan defaults in the sector have tended to be high.

The actions of the Federal Reserve were not the only economic stimulus conducted by the US Government.  The expansionary monetary policy was coupled with an expansionary fiscal policy that was conducted by the US Treasury and US Congress.  While both had varying impacts, the monetary policy of the Federal Reserve was far quicker and demonstrated the need for an independent entity that can take quick and effective action in the absence of politics.  The delays in fiscal policy approvals by the US Congress further reiterate the need for an entity like the Federal Reserve to stabilize markets quickly and independently, particularly during times of economic crisis.

It is difficult to imagine what would have happened if the Federal Reserve did not exist.  During past crises prior to the creation of the Federal Reserve, the government would have been unable to react the way that it had in response to the coronavirus pandemic, to prevent a financial or general economic crisis.  Time will tell what the net impact of the actions of the Fed will be.  While its actions stabilized the market during a critical time, they also provided a great deal of liquidity, that may have artificially inflated asset prices, in a way that may lead to significant future corrections in the months and years to come.  It does appear, so far, that what the Fed has done in response to the coronavirus has worked, but ominous signs hang in the balance.