Meanwhile, Back at the Fed ...

The Fed reached back into its bag of tricks Monday morning, releasing a new slew of measures aimed at boosting liquidity in financial markets and credit to businesses under stress from COVID-19 containment efforts. On the bright side, they seem to have learned from the panic their announcement last week created, and refrained from announcing the new moves on a Sunday. But as with the prior sets of crisis-related actions, we think these new programs are an overall mixed bag that raise some longer-term questions.

As is usual with Fed announcements, the official releases and associated news coverage came with a lot of jargon. So here, for your convenience, is a (hopefully) simple roundup of everything they did:

• Expanded the new round of quantitative easing (QE) asset purchases from $700 billion ($500 billion for US Treasury bonds and $200 billion for mortgage-backed securities) to an unlimited dollar amount, running indefinitely
• Created a new facility to purchase investment-grade corporate bonds and investment-grade corporate bond ETFs
• Tweaked bank capital rules so that banks will not be penalized and forced to constrain lending if their capital ratios fall below the regulatory minimum
• Announced unspecified “new programs” to directly finance “employers, consumers and businesses” with up to $300 billion, with the Treasury kicking in $30 billion
• Created the “Primary Market Corporate Credit Facility” to buy bonds and lend directly to large investment-grade companies
• Revived a 2008-era program called the “Term Asset-Backed Securities Loan Facility,” which will enable and fund the securitization of student, auto, credit card and Small Business Administration loans
• Expanded some money market fund and commercial paper liquidity programs to include the purchase of municipal debt

That is … a lot. Headlines have largely applauded all of it, praising the central bank’s flexibility, creativity and decisiveness. There is a lot of talk about the Fed clearly doing “whatever it takes” to get the country through this very tough time. We, too, will tip our hat to this—but only up to a point. Last week, there was a clear shortage of liquidity as everyone was selling assets and scrambling for cash. People and companies alike are hoarding dollars, and some provisions of Dodd-Frank made it hard for banks to meet that demand. Before 2008, banks played a key role as market makers. Limits on proprietary trading severely curbed their ability to do this, taking a big buyer out of the market. If the Fed can restore some of that liquidity through some or all of these new programs, we can see some short-term benefits. Similarly, while we think many observers are overestimating the degree of trouble in corporate bond markets—something we will explore in more depth in the coming days—if the Fed wants to try calming corporate yields by giving investors a free put option, we guess we can see the appeal. (The muni debt stuff, we admit, we don’t get the need for at all—perhaps it is a pre-emptive strike?)

At the same time, we have to wonder about the necessity and wisdom of all of this, and not just because we don’t think QE works (more on that here). This is the second crisis in a row where the Fed has stepped in with an alphabet soup of complicated new programs to backstop the financial system. Do the backstops shore up confidence, as central bankers intend? Or do they erode it by making every corner of financial markets appear as if they require extraordinary intervention? This is an academic question, but it is one we think wasn’t fully answered in the wake of 2008, and we think it would benefit from more scrutiny as the dust settles.

We raise these questions because historically, the Fed had some very simple tools at its disposal to increase liquidity. First, it could reduce reserve requirements—which it did last week, taking them to zero, so we award a gold star. Second, it could drop the discount rate below the fed-funds rate. The discount rate applies to banks’ borrowing from the Fed. The fed-funds rate applies to their borrowing from each other. If the discount rate is below the fed-funds rate, banks can borrow from the Fed and lend to each other for a small profit—an incentive to get money moving through the financial system. They didn’t do that in 2008, which we found curious. Now we again have to wonder: Would dropping the discount rate below fed-funds erase the need for at least some of these programs? Or, a longer-term question with big political and regulatory implications: To what extent should society rethink regulations that contribute to strengthening banks but sap liquidity and hamper other corporations’ ability to access credit markets?

Another curiosity: The Fed seems to have dramatically expanded its role as lender of last resort. On the bright side, this is the opposite of what it did in 2008. Then, it stood by as giant financial institutions ran out of cash to meet short-term obligations, forcing them into failure simply because they were illiquid. We still consider that a devastating abdication of its responsibilities. This time, not only is the Fed not abdicating, but it is apparently going to lend directly to the public. This is new. Usually, “lender of last resort” means “lender of last resort to banks,” as in, place banks can go for short-term cash when they can’t access it on the open market. Now the Fed appears to be stepping in as lender of last resort to investment-grade corporations as well as households and small businesses struggling from lost paychecks and revenues. That last part is a joint action with the US Treasury, and we half wonder if the Fed felt forced to intervene because of Congress’s extended debate over the stimulus and crisis management bill. We very much look forward to getting to read the relevant Fed transcripts five years from now. At any rate, this is another instance of the Fed taking an action that risks giving investors the impression it sees something to panic about.

Again, we aren’t trying to rain on anyone’s parade. When there is a liquidity shortage, and the Fed can do something to address it, the short-term benefits are obvious. Backstopping financial institutions’ bonds was a turning point for bank liquidity back in 2008. It helped restore confidence and got the wheels turning again. To the extent any of today’s actions have a similar impact on corporate, consumer or small business credit, it is probably a net benefit.

But keep your expectations in check. As we have said before, none of this is stimulus. It is more of a temporary replacement for lost revenues and other missing dollars—a financial lifeline to get businesses through a difficult period without having to close. None of this helps ease the immediate economic consequences of COVID-19 containment, though. The only true, lasting economic salve will be for the disease to fade, enabling businesses to reopen and people to return to normal life. The Fed can’t do that—and neither can fiscal stimulus, for that matter. It can extend a temporary, limited helping hand. But it is no knight in shining armor.

So cheer the Fed if you like—or jeer it, if you are more inclined to side with the skeptical aspects of our analysis. Up to you. Ultimately, though, a lesson that the recovery from 2008’s crisis teaches is that you don’t need perfectly sensible Fed policy for the market to recover. Today, markets have a little more liquidity than there was on Friday—and that is about all that matters.