One year ago the U.S. economy was robust with unemployment at historically low levels and real incomes rising. No one would have predicted that a year later the economy would come to a halt and more than 20 million people would be applying for unemployment benefits. This reversal was not due to monetary instability, which has been the primary cause of most recessions, but rather to a decision by government officials to mandate business closures to battle a pandemic. The initial sharp supply-side effect of COVID-19 quickly turned into a strong demand for cash and a corresponding decline in the velocity of money.
Fed’s Response to the Pandemic
The Fed responded rapidly and dramatically to keep the U.S. economy from descending into depression. Monetary policymakers reduced the benchmark fed funds rate to near zero; promised to more than double the size of the Fed’s balance sheet by engaging in large-scale asset purchases of Treasuries and mortgage-backed securities, with the intent of reducing longer-run interest rates; and restarted or created a number of special purpose vehicles (SPVs), which are off the Fed’s balance sheet, to stabilize a broad array of financial markets.[1] The U.S. Treasury has worked closely with the Fed to backstop lending and increase leverage, providing $454 billion to cover potential losses from the Fed’s lending programs to private firms under the CARES Act (an acronym for Coronavirus, Aid, Relief, and Economic Security). With leverage estimated at 10 to 1, the Fed may lend as much as $4.54 trillion—none of which would show up as part of the federal deficit (see Ip and Torres).
Risks to Monetary Control and Independence
By monetizing much of the new federal debt and engaging in credit allocation, the Fed risks sacrificing monetary control and its independence. Of course, the Board of Governors could increase the rate of interest it pays on excess reserves to keep inflation at bay. However, in so doing, it would deprive the Treasury of revenue to help reduce budget deficits.
The more serious issue for the Fed’s credibility and independence is the drift into fiscal space. As Charles Plosser, former CEO and president of the Federal Reserve Bank of Philadelphia has warned: “Independence is drifting away and after this [Covid-19] crisis it will be easier and easier for politicians to seek Fed participation in off-budget fiscal actions.”[2]
The Fed’s decision to set up SPVs to purchase corporate and municipal debt opens the door for all sorts of mischief (see Timiraos). Likewise, the Term Asset-Backed Securities Loan Facility (TALF) now accepts more risky assets, including commercial mortgage securities and collateralized loan obligations. As such, the Fed will be buying “the worst shopping malls in the country and some of the most indebted companies.” Consequently, “the opportunities for losses will be that much greater,” according to an editorial in the Wall Street Journal.
Read the rest of this post →