The Fed Goes to War: Part 2
In this note, we update our earlier comment on the first set of Fed actions that appeared on March 23 just as a slew of new ones arrived.
While most of the changes represent simple extensions of previous tools, the Fed also has introduced facilities that are going to involve it deeply in the allocation of credit to private nonfinancial firms. Choices of whom to fund are inherently political, and hence destined to be controversial. Engaging in such decisions will make it far more difficult for the Fed eventually to return to the standard of central bank independence that it has guarded for decades. We urge the Fed to limit its involvement in the allocation of credit to the private nonfinancial sector. And, should Congress deem it necessary, we encourage them to provide explicit authorization to the Treasury (along with the resources) to take on this crisis role.
Turning to the Fed’s newest actions, here is the list:
QE Infinity: Outright purchases of Treasury and agency bonds (including commercial mortgage-backed securities), previously limited to $700 billion total, are now unlimited.
Primary Market Corporate Credit Facility (PMCCF): The Fed will fund a special-purpose vehicle (SPV) to purchase bonds directly from investment-grade (BBB rated and higher) firms. The purpose of the PMCCF is to provide bridge financing for a four-year term, allowing corporates to roll over their debt. Issuers need not make interest or principal payments for 6 months. The Treasury is providing an initial equity investment of $10 billion from the Exchange Stabilization Fund that the Federal Reserve can then leverage.
Secondary Market Corporate Credit Facility (SMCCF). The Fed will fund an SPV that purchases in the secondary market investment-grade bonds and exchange-traded funds that hold investment-grade bonds. The Treasury is providing an initial equity investment of $10 billion from the Exchange Stabilization Fund that the Federal Reserve can then leverage.
Renewal of the Term Asset Backed Securities Loan Facility (TALF). This revives an expired policy tool from the 2007-09 crisis. The TALF SPV aims to purchase asset-backed securities other than those backed by mortgages. The Treasury is providing an initial equity investment of $10 billion from the Exchange Stabilization Fund that the Federal Reserve can then leverage. The initial volume will be up to $100 billion, implying leverage of 10:1.
Changes to the Money Market Mutual Fund Liquidity Facility (MMLF) to accept a wider range of collateral, including debt instruments (including municipal debt) purchased from money market mutual funds by eligible intermediaries.
Changes to the Commercial Paper Funding Facility (CPFF) to allow it to hold tax-exempt issues.
The announcement of a plan to establish a Main Street Business Lending Program―stay tuned!
Some of the items on this list constitute simple extensions of last week’s actions to revive expired crisis policy tools. The goal remains to counter market dysfunction and, where necessary, to substitute for private intermediation. The expansions of the MMLF and CPFF, as well as the resurrection of the TALF, fit in this category. Over the course of the 2007-09 crisis, the TALF issued a very modest $70 billion in loans. The new TALF’s anticipated $100 billion capacity represents about one-quarter of average annual issuance in recent years.
The Fed’s removal of limits on large-scale asset purchases—what is now widely called QE Infinity—aims at supporting aggregate demand. It wasn’t until 2012—more than three years after the end of the 2007-09 crisis and recession—that the Fed removed the limits on its balance sheet expansion. Given today’s concerns about the depth of the coronavirus recession, it is likely that there will be a need for massive support of aggregate demand. From this perspective, the Fed’s announcement is akin to announcing: “the cavalry is on the way.”
For now, however, the key to restoring economic activity is not central bank action but an effective response to the public health threat. Put differently, supporting aggregate demand has little sustained impact on production in an environment where the problem is one of severe supply constraints with a large swathe of U.S. labor on lockdown. (We recently saw an estimate that over half of U.S. hourly workers, representing nearly one-third of total employment, are not going to work.)
Compared to these developments, we are far more concerned about the two new Fed programs to maintain the availability of corporate credit—the PMCCF and the SMCCF. It is natural for the central bank to take on a key role in supporting the government’s crisis management efforts. However, our fear is that these programs, which require the central bank to engage in highly controversial distributional decisions, will threaten its credibility and make it far more difficult to restore central bank independence when the crisis recedes.
Before we get to that, we should step back and explain our view of the role of a central bank in a crisis. As we discussed in our prior post, at times like these, central bankers’ primary objective is stability of the private financial system: stabilize private financial firms and markets as quickly as possible, and then get out. Broadly speaking, this means acting as both a lender of last resort and a market maker of last resort. The purpose of the first is to stem runs and panics on institutions engaged in liquidity and maturity transformation, while the second restores investors’ ability to buy and sell securities. Encouraging banks to borrow through the discount window, and providing financing to liquidate high-grade assets of money market mutual funds, are clear lender of last resort operations. (We would put the expired term auction facility in this category as well.) Lending to primary dealers and offering an enormous repo facility are examples of the latter.
Importantly, the purpose of all of these actions is to ensure markets continue to function and to provide a backstop to the private sector so that they feel sufficiently comfortable to restart intermediation. Under duress, the central bank has served as an intermediary for private lenders and borrowers. Two examples of this are the Fed’s purchase of MBS in 2008 and 2009 and the implementation of the original CPFF in October 2008. In the case of MBS, keep in mind that the market began to collapse in mid-2007, but it took until October 2008 for the Fed to start purchasing the securities outright.
The purchase of corporate bonds, especially in the primary market, is something wholly different. This is fiscal policy, pure and simple. Politicians are always tempted to try to use the central bank’s balance sheet for political purposes. More than just acting as a fiscal agent, managing the government’s finances, the central bank can provide resources by simply expanding its balance sheet at the behest of the Treasury.
In our view, this undermines democratic accountability. It is Congress that should allocate resources for acquiring private assets (like corporate debt). Congress can mandate that Treasury carry out its plan and authorize any needed increase in the debt ceiling, rather than use the Fed as an off-balance sheet vehicle. Elected representatives can then hold the Treasury and its fund managers accountable for how they allocate (or misallocate) the funds.
From this perspective, the repeated use of the Exchange Stabilization Fund (ESF) to provide credit protection for the Fed to acquire private assets is an unnecessary and a potentially dangerous shortcut. (While the ESF’s $50 billion commitment to support Fed policy tools represents more than half of its current resources, reportedly the Congress is poised to add far more.) Keep in mind that the Fed has no expertise in managing these assets and has already outsourced this project to BlackRock (much as it did in 2008 when it announced the acquisition of MBS). If Congress and the President were to act, there is no reason that Treasury could not take over this project, outsourcing it to the degree that they felt necessary.
Moreover, in the short run—over the next three months or so―there is a less damaging private alternative. At the cost of a modest decline in their regulatory leverage ratio, federal government authorities (including the Fed) could encourage U.S. banks to absorb the rollover of commercial paper and investment-grade corporate debt. The numbers speak for themselves: The entire commercial paper market is currently a bit under $1.2 trillion, with an average weighted maturity of 2 months; while something like 1% of the $7.2 trillion worth of investment-grade corporate bonds outstanding roll over each month. Financing all of the commercial paper plus three months of investment-grade corporate bond issuance requires less than $1.5 trillion. By our rough calculation, if U.S. commercial banks were to absorb all of this, the system’s average leverage ratio would fall from about 7.5% to 7%―hardly catastrophic. (The Basel III measure of exposure for the U.S. banking system is roughly $22 trillion, and common equity tier one is about $1.7 trillion.)
Getting banks to do this would surely require some combination of regulatory forbearance on issues like marking assets to market and expected loss provisioning, as well as government guarantees (from the Exchange Stabilization Fund?) to backstop the ultimate value of the securities. But, wouldn’t it be better to engage the private sector in rescuing fixed income markets than for the Fed to simply take it over?
We fully understand the need for the Federal Reserve policymakers to join forces with others in the government to manage the current crisis. Nevertheless, we hope that they will limit the central bank’s role in the allocation of private credit, both in scope and in time. When it comes to purchasing private nonfinancial sector debt―either bonds or loans (as authorities seem to envision in the not yet announced Main Street Lending Program)―there is no justification for bypassing elected officials. One alternative, proposed by our wise friend, Kathryn Judge, is for Congress to authorize the Fed’s credit allocation activities that are clearly at the center of the new corporate bond purchase facilities. If the Fed is to continue down this path, we consider such after-the-fact approval the minimum needed to legitimize its efforts.
Otherwise, how can we ever regain the central bank independence that Fed officials so carefully guarded and maintained for half a century?