It really is true. What goes around comes around. Please note that this Murphy Center piece is co-authored, a first for this column. Cliff Sowell and I have been friends for years, meeting as graduate students in the economics department at the University of Georgia. While we went our separate ways, Cliff to Berea College in Kentucky and me to Mercer in Macon, we always worked together in research and publishing. A good bit of it could be described as being centered around ‘What has the Federal Reserve Done?’ See what I mean? So, here is our view of the meaning of recent Federal Reserve policy moves.
On March 15-19 the Federal Reserve, the central bank of the United States, announced a number of policy changes in response to COVID-19. While it is clear why the CDC — Center for Disease Control and Prevention — and other federal, state and local health agencies fit into this, how does the Fed?
First a bit of history. In part, initiated with the famous meetings on our own Jekyll Island in 1907, the Federal Reserve was created in 1913. Its primary function was to keep banks from failing by being a lender of last resort. A feature of the financial landscape at the time was one of bank runs and panics; periods of unanticipated currency withdrawals from banks. The idea was that commercial banks could go to the ‘discount window’ at their Federal Reserve district banks with certain loans (commercial paper) and offer them as discounted collateral to get currency which would be used to stop the run.
So, the Fed was created to supply liquidity to the economy caused by repeated financial crises in banks and financial markets. While things have changed and functions expanded, the Fed, as it has in earlier episodes, assumed this role through open market operations and other policies to lower bank overnight lending rates.
The latter were used in 2007-2008 due to the collapse of the mortgage market and runs on private shadow banks, for example Lehman Brothers and Bear Stearns.
The Fed used its policy tools to address the lack of liquidity and stability in financial markets. These policies were referred to broadly as quantitative easing or occasionally, qualitative easing or QE. Collectively QE broadened the assets that the Fed was willing to purchase from banks beyond U.S. government debt to include primarily mortgage backed securities (MBS).
This led to large increases in the Fed balance sheet as qualitative easing involved the broadening of security risk through the type of discount window collateral accepted. In addition, the Fed created the Primary Dealer Credit Facility to enable emergency short term lending to primary dealers in new and existing government debt in order to accept riskier collateral for example, investment grade corporate debt.
The Fed’s current string of announcements are about the same set of policy tools used in 2007 and 2008 but in much larger amounts. Current Fed policy is again directed at the lack of liquidity and stability in financial markets. However, financial markets did not react positively to these actions. We think this is because today’s problems are not solely due to the lack of liquidity and stability in financial markets. At this point it is uncertainty over the extent of the health crisis and it’s impact on credit and cash flows of businesses and households that matter most. The problems are different, yet the tools are much the same.
For example on March 17, the Fed announced something new (but old) to address this crisis and the associated cash flows issues. The Fed announced that it would add liquidity to the commercial paper market by lowering the discount window rate and removing the stigma attached to its use. This facility allows banks to more readily make loans collateralized by commercial paper. With broadened bank use of this facility, distressed firms can suffer declines in sales but get cash in order to support operations and continue to employ workers. The first goal of business is to manage cash flow. Little else can be done without proper cash flow management. And, late on the same day the Fed announced the revival of the Primary Dealer Credit Facility. New (but old) policy rollouts and initiatives are now a daily event.
In terms of economic policy, we all must remember that our current situation is only temporary. While we have never been through something like this, an end will come into sight.
How bad it gets here depends critically on many things: extensive use of social distancing (do the right thing millennials), if and when a treatment and vaccine become available and the level and scope of the coming fiscal stimulus. When these happen, and uncertainty declines, things will start to quickly return to normal. This was not the case for the last great recession. It, too, was something that we had not experienced nor knew what the end looked like and when that might come. In some areas of the country, the end came sort of quickly. In the Golden Isles, the end was a long time coming.
We felt like you all were owed this analysis. We hope you learned something new or found something you could use. If there was, you should hear our dinner conversations.