Fed Quick Take: Throwing the kitchen sink

In another emergency meeting, the Federal Reserve Board today announced several measures to support the US economy and prevent a liquidity and credit crisis. To put it bluntly, after the announcements on Thursday to provide up to $5tn in short-term liquidity didn’t calm the market, the Fed is now throwing the kitchen sink. 

In summary:

• The target range for the Fed Funds rate has been lowered another 100bps to 0% to 0.25%.

• The Fed also re-introduces quantitative easing and will purchase $500bn of Treasuries and $200bn of Mortgage-backed securities. All proceeds from maturing securities on the Fed’s balance sheet will be reinvested in Treasuries and agency MBS again.

• The Fed also “re-opened” the discount window by cutting discount rates by 150bps to 25bps for deposit-taking institutions. This cut reflects the 100bps. Cut in Fed Funds Rates and an additional 50bps. Narrowing of the discount rate relative to the Fed Funds Rate to encourage banks to make use of the discount window and avoid a liquidity crisis.

• The Fed also encourages banks to use their liquidity and capital buffers to lend to households and businesses affected by the Covid-19 pandemic. The Fed states that the largest banks in the US have $1.3tn in equity capital and $2.9tn in high-quality liquid assets. To support lenders to engage in lending activities, the reserve requirements for lenders will be cut to 0% as of 26 March 2020.  

Finally, the Federal Reserve has launched an internationally coordinated action to enhance US Dollar liquidity. The Fed, together with the Bank of Canada, the BoE, the ECB, the Swiss National Bank and the Bank of Japan will lower the interest rate on US Dollar liquidity swaps to the overnight index swap rate (OIS) plus 25bps. In addition, the foreign central banks will start offering not just the usual weekly US Dollar swaps but also 84-day swaps. 

In short, the Fed has gone full 2008. Except for massively widening the amount of quantitative easing, there is practically no monetary policy tool available to the Fed anymore to calm the markets. All the Fed can do now is watch and provide all the liquidity the world needs to prevent a meltdown of the financial system like the one we almost witnessed in 2008 and 2009.

The economic fallout of the Covid-19 pandemic will have to run its course and with the Fed reduced to lender of last resort and ultimate liquidity provider we will need fiscal stimulus to prop up the economy.

The Coronavirus Law passed by Congress on Friday does provide a first step in the right direction:

• It provides free testing for Coronavirus infections to everyone and a 6.2% increase in federal spending on Medicaid. The National Disaster Medical System receives $1bn to pay for testing for uninsured people.

• Employees and workers in companies with less than 500 employees as well as government employees receive two weeks of paid sick leave and up to three months of paid medical and family leave of at least two-thirds of their salaries. These measures are taken to encourage people to follow medical advice and self-isolate when needed. Companies who are covered by this regulation can claim tax credits to compensate for the additional costs.

• The government spends $1bn to provide access to food for poor people and others who may struggle to get access to nutrition during the pandemic.

• Another $1bn is pledged to states to help them with the processing of unemployment benefit claims. 

In total, these measures amount to additional government spending of about $8.3bn or about 0.04% of US GDP. In other words, this is no fiscal stimulus, just a band-aid to help with the most immediate needs.

This also means that Congress will have to act in coming months, if the Covid-19 pandemic spreads and creates a bigger economic impact. The list of countries shutting down borders, public buildings, schools and other public gathering places is getting longer and longer. And while global trade of goods is not hindered by these measures, it is increasingly clear that these measures to slow down the spread of Covid-19 are likely to cause a recession not just in the Eurozone where growth was already slow before the pandemic, but increasingly so in the UK and the United States. Personally, I still think the downturn will be short-lived and we see a recovery in the second half of 2020, but everything is possible. 

Finally, to put the current measures of the Fed in perspective, I reproduce a chart from Ernie Tedeschi who estimated the GDP boost from different policy measures ranging from a 100bps Fed Funds Rate cut (where we are now) to different fiscal policy measures. His piece is worth reading in any case. It shows nicely how the current Fed policy measures suffice to deal with the economic fallout of Covid-19 if the global economy does not enter a recession. But if we face a global recession or a steeper decline in US economic activity we will need drastic fiscal stimulus such as a payroll tax holiday like we have seen in 2009.