U.S. Monetary Policy during the COVID-19 Outbreak - New Developments and Future TrendsInsights SRD/New York Research Center
1. The Federal Reserve has made QE (quantitative easing) a conventional policy tool and is trying to monetize both government debt and Federal fiscal policy. After the 2008 crisis, the Fed initiated large-scale QE programs, gradually alienating the relationship between monetary policy and the size of the Fed’s balance sheet, creating opportunities for the Fed to use its balance sheet for funding extra-budgetary transactions and credit allocations, which are independent of interest rate policies.
Since then, the Fed has normalized QE as a conventional policy tool, which has been magnified by the recent COVID-19 outbreak. As national debt continues to rise and remains high, the Fed must reduce the cost of debt by maintaining large-scale Treasury purchases, meaning that as long as inflation is stable, the Fed will not reduce its balance sheet significantly for an extended period of time.
From a theoretical standpoint, QE is actually the prototype of the monetization of government debt advocated by the “modern monetary theory” (MMT), both of which are a form of transferring debt to newly created money, and can increase the money supply as long as there is unexhausted economic capacity. If the Fed and the government further cooperate in the monetization of fiscal policy, QE will develop into a complete practice MMT. That is what happened after the outbreak, and its main hallmark is the Fed’s unlimited QE.
2. The Fed's policy of supporting economic recovery gradually shifted from monetary to credit policy, as well as from emergency measures for market stabilization, to a long-term strategy supporting economic recovery. Fiscal policy monetization, at the same time, has further deepened into credit policy monetization.
The Fed's traditional credit policy was previously limited to providing liquidity as a lender of last resort to the financial system, which is temporarily illiquid, and the discount window used to be the main channel. Since the 2008 crisis however, the Fed began, using tools to provide direct and indirect credit support to non-financial firms. Since the outbreak, the Fed has also significantly expanded the size and scope of its credit policy tools.
The changes in the Fed's policy path reflect the evolution of financial market risks:
At the beginning of the crisis, the main risks pertained to market and liquidity risks. These were usually shorter and broader, and required the Fed's monetary policy to provide adequate liquidity responses. The Fed’s emergency tools and programs, which were first developed and implemented in March, focused mainly on the availability of broad market liquidity, resulting in a rising money supply, an easing of the liquidity crisis, and improving market stability.
The second stage of crisis development is economic recovery and the increased risk of default. This process is often longer, more complex and customer-oriented, and requires targeted credit policies and banks’ involvement. The U.S. economy began to recover after May, but the risk of default was also rising at the same time.
There needs to be a greater shift from universal monetary policy to credit policy. The Fed has aggressively cut back on Treasury purchases and stepped up efforts to provide direct credit support to specific targets. Since these credit instruments adopted by the Fed are still part of its monetary policy, and their liability side is in fact the Fed's newly created money supply, it is largely a model for monetizing credit policy. The Fed's recent programs around corporate bonds, ETF purchases, and direct lending showcases its efforts to become more of an active portfolio manager, rather than a liquidity provider and lender of last resort.
3. The Fed's off-balance-sheet assets rose sharply.
Section 13(3) of the Federal Reserve Act authorizes the Fed to provide emergency liquidity and loans to businesses in exceptional and emergency situations. The Fed took full advantage of this provision amid the COVID-19 outbreak, based on the CARES Act by setting up an SPV, expanding off-balance sheet assets, and making off-balance sheet lending the main channel for credit policy implementation. There are currently 11 such instruments, all of which are characterized by stabilizing short-term funding markets and provide direct credit support to the economy as a whole.
Based on the plan, the U.S. Treasury Department provided $454 billion in initial capital to support the Fed's lending facilities and to cover for possible losses. The leverage rate of this initial capital is 1:10, which means that the Fed can lend up to $4.54 trillion.
This actually opens up another huge window in the Fed's monetization of fiscal and credit policies. The expansion of off-balance sheets allows the Fed to control and even reduce QE size, as well as shrink its balance. The off-balance sheet assets however, are still currencies created by the Fed, with effects similar to that of balance sheet expansion and QE. This means that depending on the stimulus that Congress and the Treasury Department agree upon, it will be up to the Fed to create money to meet its funding requirements. A typical case of off-balance sheet assets at the Fed would be a main street lending program for small businesses.
4. The Fed may conduct yield curve control.
This tool would mean the Fed would target a specific yield at a specific maturity (or series of maturities) and purchase enough bonds to prevent the bond yield for that maturity from rising. The Fed may, in the future, initiate yield curve control due to the following reasons:
- As the economy recovers and QE volumes decrease, long-term yields are likely to continue rising, affecting the strength of the economic recovery. However, since the start of the outbreak, the Fed has exhausted almost all its tools. If negative interest rate options are rejected, yield curve control may be the only option for maintaining long-term low interest rates while avoiding a significant flattening of the yield curve.
- Long-term treasury rates are viewed as a common benchmark for loan pricing and need to remain relatively low. This, however, could lead to a flat yield curve and inflict pressure on investors' returns. The Fed needs to take steps to drive down short- and medium-term interest rates to maintain a relatively low but steep yield curve. One way to achieve this is through keeping its 2-, 3-, and 5-year Treasury bonds at predetermined levels by buying or selling them.
Given the current market state, the need for this approach may be weakened by market expectations around future short-term Treasury yields, market expectations around the yield curve control approach, recent re-issuance of 20-year Treasury bonds by the Treasury Department, as well as the Treasury’s plans to issue more longer-term bonds, which has also led to an expansion of short- and long-term spreads.
The Fed will also use more forward-looking guidance on long-term low interest rates and make large purchases of short-term government bonds before considering a yield curve control approach., indicating that the Fed is expected to consider this approach when other methods no longer effectively form a low and steep yield curve.
5. Implications for the banking industry
For banks, low interest rates and sufficient liquidity will go on for an extended period of time. Given the fact that the bank’s balance sheet is more assets-sensitive towards interest rates in general, the banks’ NIM will be under pressure for a long time. Banks will have to improve their own asset and liability management to reach a higher NIM.
The Fed’s efforts to steepen the yield curve, with or without yield curve control, will improve the banks’ interest income, as banks need to conduct timely and accurate predictions around interest rate trends in order to manage their balance sheet better. Additionally, the Fed’s intervention in credit markets has made the default risk of both firms and households more complicated and less predictable. As a result, banks need to put more resources towards evaluating and handling loan delinquency and default risks.
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