The Fed Goes to War: Part 3
“Our emergency measures are reserved for truly rare circumstances, such as those we face today. When the economy is well on its way back to recovery, and private markets and institutions are once again able to perform their vital functions of channeling credit and supporting economic growth, we will put these emergency tools away.” Federal Reserve Board Chair Jerome H. Powell, April 9, 2020.
For the second time this century, the Federal Reserve is a crisis manager. In this role, policymakers can lend to solvent but illiquid intermediaries (as the lender of last resort). They can backstop financial markets (as a market maker of last resort). And, when all else fails, they can take the place of dysfunctional private-sector intermediaries.
During the first financial crisis of the 21st century, the Fed’s response shifted from one role to the next as the crisis intensified. Yet, even compared to that massive crisis response, the Fed’s recent moves are breathtaking—in speed, scale and scope.
Indeed, with its most recent announcements on April 9, the Federal Reserve is committed to an unprecedented course of action to ensure the flow of credit to virtually every part of the economy. In carrying out its obligations under the newly enacted CARES Act, the Fed is effectively transforming itself into a state bank that allocates credit to the nonfinancial sectors of the economy.
Yet, picking winners and losers is not a sustainable assignment for independent technocrats. It is a role for fiscal authorities, not central bankers. Instead of using the Fed as an off-balance sheet vehicle for the federal government, we hope that Congress will shift these CARES Act obligations from the Federal Reserve to the Treasury, where they belong.
As we discuss in two earlier posts (here and here), over the course of only a few weeks in March, the Fed reprised everything they did in 2008 and 2009. As a lender of last resort should, they began lending both to banks and to non-banks. In doing so, they acted to prevent de facto banks from becoming a source of runs and panics (see here and here). Similarly, the Fed lent to brokers and dealers to help them make markets. And, in places where it had eroded, they engaged in outright purchases and collateralized lending arrangements to restore market function.
Since then, in the unforgettable words of Toy Story’s Buzz Lightyear, they have gone to infinity and beyond, operationalizing CARES Act arrangements to lend to nonfinancial corporations, small businesses and municipalities. Even at the height of the 2007-09 crisis, the Fed did very little of this. For example, the vehicles it created to purchase commercial paper and asset-backed securities were relatively small: at the time, nonfinancial firms accounted for a modest 20% of the less than $1 trillion of commercial paper outstanding, while the Fed’s Term Asset-Backed Securities Lending Facility (TALF) peaked at $48 billion.
Before turning to the details of the newest programs, it is worth having a look at the size and composition of the Fed’s balance sheet. Much of the following chart is now familiar. Prior to 2008, the Fed had less than $1 trillion in assets. Over the next six years, holdings grew to $4.5 trillion. Decisions in 2017 led to a gradual contraction, with the balance sheet temporarily retreating below $3.8 trillion. In September 2019, in response to some modest stresses (see here), officials reversed some of the decline, nudging assets back over $4.1 trillion as of February 2020.
Consolidated Balance Sheet of the Federal Reserve System, weekly, 2007 to 2020
Source: Federal Reserve Bank of Cleveland.
Looking at the most recent data, there is an enormous spike. Over the past four weeks, in response to the COVID-19 crisis, Fed officials have managed to increase the size of the balance sheet by $1.7 trillion—even faster than at the height of the previous crisis! Fed holdings of Treasury securities are up by $1 trillion; central bank swaps jumped to $350 billion; and lending to banks, to primary dealers and for the support of money market mutual funds, rose by $100 billion.
Yet, as extraordinary as the last month has been, this is really just a warm-up. We fully expect the Fed’s balance sheet to rise to $8 trillion over the next few months.
That brings us to the programs announced since March 17 (listed in the table at the end of this post). The first five are consistent with the Fed’s traditional crisis role as a lender and market maker of last resort. Four of these simply revive programs from 2008-09. The Primary Dealer Credit Facility (PDCF) and Money Mutual Fund Liquidity Facility (MMLF) provide loans to financial intermediaries. While the Commercial Paper Funding Facility (CPFF) and Term Asset-Backed Securities Facility (TALF) likely will provide some support to nonfinancial firms, it will remain relatively small. The Paycheck Protection Program Lending Facility (PPPLF) is new, but it does not involve the Fed taking on credit risk. The U.S. government is guaranteeing all of the loans of the Small Business Administration’s PPP program. If these loans were securities, the Fed would be able to purchase them outright, as they do with mortgage credit guaranteed by the government-sponsored enterprises.
The remaining five programs all involve a very large allocation of credit to nonfinancial entities: the Primary and Secondary Market Corporate Credit Facility (PMCCF and SMCCP), the Municipal Liquidity Facility (MLF), and the Main Street New and Expanded Loan Facilities (MSNLF and MSELF). In an earlier post, we discuss how the corporate credit facilities can supply credit directly to firms that historically had direct capital market access.
Turning to the other three facilities, the MLF can purchase notes maturing in 24 months or less issued by states, cities or counties for the purposes of managing their cash flows. While there are nominal limits on the amount the MLF can purchase from any individual issuer, a state government can request a waiver (see here).
The Fed released term sheets that outline how the MNSLF and MSELF will work (see here and here). They will finance new loans of $1 million to $25 million to any U.S. firm with fewer than 10,000 employees (or less than $2.5 billion in 2019 revenue), for a four year term (with the first year deferred) at a rate of 250 to 400 basis points over a safe rate (SOFR). Rules restrict the distribution of profits and forbid firms from using these loans to repay existing debt. The MSNLF and MSELF will take a 95% participation in the loan, leaving 5% with the originating institutions (presumably a bank).
At their current authorization, the corporate bond, municipal liquidity and main street facilities have a combined limit of $2.3 trillion, of which $195 billion is coming from the U.S. Treasury. So, these could add another $2 trillion to the Fed’s balance sheet.
In and of itself, this balance sheet increase presents little challenge for the Fed to manage. What is troubling is the new role for the Fed as a state bank engaging in the politically sensitive allocation of credit to nonfinancial firms, as well as to state and local governments. The Fed’s new facilities will lend directly to private and public bond issuers, including state and local governments; as well as provide loans to medium and large firms.
Granted, the Fed is on a wartime footing, so it has clear justification for using every tool at its disposal to support the government’s battle against the coronavirus. It should ensure that the financial system is able to perform its critical functions of facilitating payments and delivering credit to healthy borrowers. Moreover, as in World War II, the central bank should be prepared to help limit the cost of financing the government’s battle against COVID. However, since Treasury funding costs are at or close to record lows, this is not an issue―at least, not yet. (For a discussion of the Fed’s role before, during and after WWII, see Humpage and Carlson and Wheelock.)
Our real concern is that the Congress, through the CARES Act, is relying on the Fed to allocate credit to the nonfinancial sectors of the economy. That means deciding who should receive subsidized credit and who should not. Should credit go only to investment-grade firms or, as the Fed just decided, also to sub-investment grade firms? Should corporate financial conditions continue to erode, will officials be able to resist the temptation to reduce the rating threshold for the bonds they purchase for a second (or third or fourth) time? Should the credit restrictions be the same across businesses or—as currently seems to be the case—should they be less stringent for corporations than for small and medium-sized businesses? Should some sectors—automobiles, defense, pharmaceuticals—have greater priority? Should authorities distribute credit to achieve fairness—say, across states and municipalities―or should they allocate it to maximize production and employment?
In a democratic society, obligating an unelected, independent authority to make such decisions does not convey legitimacy. (Our friend Paul Tucker has written about this at length. We discuss his logic here.) Instead, over time, it undermines the authority’s independence, making it an intense target of political pressure. Will the winners be those nonfinancial entities who are most successful at lobbying the Fed (or the government) to include them in a favored credit category? Will they be those who are most successful at lobbying to remain in a favored credit category long after their performance warrants it?
Under such pressure, will the Fed really be able to put these emergency tools away when the economy is on a path to recovery? If not, will the long-term state-bank allocation of credit promote healthy economic growth, or will it—as the experience of other countries suggests—support politically favored activities?
So, why did Congress choose this CARES Act structure? For one thing, it avoids having to authorize and issue additional Treasury debt. After all, when the Fed makes a loan of any kind, it simply creates a reserve liability. In theory, these reserves constitute debt on the consolidated balance sheet of the entire government. Legally, however, they are not Treasury securities. To put it bluntly, Congress can use the central bank as an off-balance sheet entity to finance activities without explicitly borrowing. Finally, from the Treasury’s perspective, when something goes wrong with the CARES Act lending, it can shift blame to the Fed. In other words, in settling on this formulation, elected officials are abdicating responsibility.
There is an obvious alternative to the current structure. Congress could have given the Treasury a mandate, together with the budgetary authority, to deliver credit directly to nonfinancial firms and to municipalities. Rather than burying the lending in various special purpose vehicles tethered to the Fed’s balance sheet, the arrangements would appear transparently on the Treasury’s own balance sheet. Treasury could have called on the Fed as needed for its expertise or, just as the Fed is doing, hire private sector asset managers to carry out key tasks. And Congress could ensure effective oversight by mandating frequent and comprehensive disclosure, and holding Treasury accountable for fulfilling its mandate.
In closing, we should be clear that we strongly support U.S. policymakers in their determination to do whatever it takes within the law to support households and firms, as well as state and local governments, through the coronavirus war. We need all hands on deck to maintain health and safety at the same time that we minimize the financial and economic disruptions.
But these goals do not require sacrificing the future independence of the central bank. Let’s make sure that “whatever it takes” doesn’t turn in to “what have we done?”.
Selected Federal Reserve Policy Tools Announced Since March 17, 2020
Notes: Multiple dates reflect initial announcement of and subsequent modifications to the policy tool. Sources: Federal Reserve press releases and term sheets, Federal Reserve H.4.1. release (balance on April 8), Federal Reserve Commercial Paper release (outstanding), SIFMA database (bonds and ABS outstanding), Federal Reserve Bank of New York (primary dealer repo), and FDIC QBP time series spreadsheets (bank loans to small businesses).