Fed's big stick lets it speak powerfully
The powerful stabilizing impact of the Federal Reserve’s COVID response is visible virtually across U.S. financial markets. Despite the deepest recession since the Great Depression, the NASDAQ is at a record high, the S&P 500 index is barely 8 percent below its peak, and U.S. equity and bond market volatilities are far below their March peaks. In addition, bond market liquidity has improved sharply, while investment-grade corporate yield spreads are now in line with their long-run norm. Even the trade-weighted value of the dollar has retraced roughly half of its March flight-to-safety surge.
What is most remarkable about this is how little the Fed has done to achieve these outcomes. To be sure, the central bank now holds $7 trillion in assets, an increase of $2.8 trillion since early March. Yet, virtually all the increase reflects large-scale purchases of government-guaranteed instruments ―primarily Treasurys and, to a lesser extent, mortgage-backed securities―plus some lending to foreign central banks to meet dollar needs abroad (see chart). What we find astonishing is that the acquisition of risky nonfinancial debt remains tiny.
Federal Reserve Assets, 2007-1 July 2020
Source: FRED.
The point is clear: backed by massive fiscal support, the Fed’s mere announcement of its willingness to purchase corporate and municipal bonds, as well as asset-backed securities, has proven sufficient to stabilize markets despite the worst economic shock since WWII. Put differently, the Fed’s willingness to backstop markets has obviated the need to serve actively as a market maker of last resort. This reminds us of how, at the height of the euro-area crisis in the summer of 2012, Mario Draghi’s July 2012 statement that the European Central Bank will do “whatever it takes” had an extraordinary stabilizing impact.
In this post, we document these developments and then speculate about their implications. For one thing, in a future crisis where the U.S. fiscal and monetary authorities share key goals, people will now anticipate that the central bank will backstop financial markets. Because a central bank is almost certain to intervene when systemic risks rise, these stabilizing powers are welcome.
At the same time, the central bank’s backstop is a source of potentially serious moral hazard. We suspect that investors are now counting on Fed stimulus to support equity and bond prices (and possibly bank loans) even as household and business insolvencies rise. Yet, in a market economy, it is shareholders and creditors who ultimately must bear these losses. Indeed, were the U.S. equity market to plunge by 40 percent in the remainder of 2020, that by itself would pose little threat to the financial system, and ought not trigger large corporate bond (let alone equity) purchases by the central bank.
Let’s start by looking at how the Fed has employed its various balance sheet tools since mid-March (see table). As we previously noted, the first group (shaded in orange) includes those introduced in the 2007-09 crisis and then quickly revived as part of the Fed’s initial COVID response. The second group (shaded in yellow) involve lending to nonfinancial entities—businesses and municipalities―and entail credit risk. Finally, while the Paycheck Protection Program (PPP, not shaded) is also new, it involves lending to banks that is collateralized by loans with full federal government guarantees, so there is no credit risk.
Selected Federal Reserve Policy Tools Announced Since March 17, 2020
Notes: Dates reflect initial announcement of the policy tool. Sources: Federal Reserve press releases and term sheets, Federal Reserve H.4.1. release (balance on July 1), 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).
Remarkably, aside from the PPP lending facility, all of these programs remain very small. The first purchases of nonfinancial corporate debt did not occur until May 19. As of July 1, with a combined $39 billion outstanding, these programs accounted for just 1.4% of the $2.8 trillion increase in the Fed’s balance sheet since mid-March. And compared to the scale of the relevant markets—more than $23 trillion—Fed holdings are only about 0.2% of the total.
While these programs may be small today, they have the potential to be much larger. In those cases where the maximum size of the facility is stated―the asset-backed securities, corporate credit, municipal liquidity and main street lending facilities―the total maximum size exceeds $2 trillion. That is roughly 175 times the Fed’s current balance of $12 billion. Moreover, for three of the revived facilities, the maximum size is unspecified. Finally, as far as we can tell Treasury has only committed half of the CARES Act funds allocated for supporting Fed financial programs, so there is the possibility of further expansion should officials judge it warranted.
Having such a big stick enhances the significance of the Fed’s various announcements. Financial market participants paid close attention, making the impact almost immediate. Two examples suffice. First, in the weeks before the March 17 revival of the Primary Dealer Credit Facility (PDCF), corporate bond issuance dried up globally—constituting one element of a world-wide “sudden stop” in market funding (see the BIS Annual Economic Report 2020, page 15).
In the chart below, the bars show this year’s weekly nonfinancial corporate debt issuance by type (investment grade, leveraged loans, and high yield), while the diamonds show the average weekly issuance for the 2015-19 period. Notably, for several weeks starting in late February, even investment-grade credits suffered. But, as soon as the Fed provided a liquidity backstop for the corporate bond market makers through the PDCF, things changed. Indeed, the subsequent announcement of the corporate credit facilities ushered in an episode in which issuance surpassed historical averages, more than making up for the lull during the previous few weeks. If the goal of announcing these programs was to ensure that healthy borrowers retained access to credit even in a crisis, these interventions were clearly both fast and effective.
Nonfinancial corporate debt issuance (weekly, billions of U.S. dollars), December 30, 2019 to June 1, 2020
Notes: The brown dashed vertical line marks the announcement date of the PDCF, while the blue dashed vertical line markets the announcement date of the corporate credit facilities. Source: BIS Annual Economic Report 2020, Graph I.8 (left panel), June 30, 2020.
Second, the Fed’s new policy tools (as well as those of central bankers in other parts of the world) appear to have rapidly altered the attitudes of retail investors to risky assets around the world. As evidence, consider the following chart that depicts the weekly net flows to advanced and emerging economy equity and bond mutual funds. Like banks, sudden declines in the value of their illiquid assets make open-end mutual funds vulnerable to runs (see Feroli et al and Chen, Goldstein and Jiang). In the weeks prior to the March 23 announcement of the Fed’s corporate credit facilities, COVID-related worries prompted large, persistent flows from bond and equity mutual funds into safer, more liquid assets. This had the clear hallmarks of a run. Yet, within a week of the announcement, (with the exception of emerging market equity funds) these flows reversed.
Investor net fund flows (weekly, billions of dollars), December 30, 2019 to June 8, 2020
Source: BIS Annual Economic Report 2020, Graph I.12 (center panel), June 30, 2020
So, we should all be relieved that—in the context of enormous fiscal support—the Fed can be so effective, so quickly. To paraphrase Churchill, never have so many people owed so much to so few policymakers who (at least so far) did so little. While it is reasonable to think that this will work again, we cannot be sure. Provided that fiscal support is present, and that the central bank-fiscal cooperation is consistent with each meeting their goals, it should. But, it is easy to think of instances where Fed announcements would be far less powerful. If, for example, inflation were to begin to rise unexpectedly, then claims to backstop financial markets (especially the market for Treasuries) could signal erosion of the Fed’s independence, severely diminishing the stabilizing impact of any further actions.
Today, the far greater concern is that investors perceive the central bank’s actions as guaranteeing asset values. The stock market provides one obvious example. Considering the state of the economy and its current prospects, U.S. equities seem richly priced: the end-June Shiller cyclically adjusted price-earnings (CAPE) ratio for the S&P 500 was nearly 30―about 75 percent above its long-term average of 17. To what extent do investors believe that the Fed would intervene to maintain prices at this level? Although the Fed does not have authority to purchase equities directly, it could follow the pattern set for the purchase of corporate bonds: create a special purpose vehicle, and then use its emergency authorities (under section 13(3) of the Federal Reserve Act), together with a Treasury backstop, to lend to the SPV. Having witnessed the enormous impact of the aggressive monetary policy actions over the past few months, it would not surprise us if some investors believe that the Fed is willing to put a floor under the equity market through the introduction of an “Equity Market Liquidity Facility.”
Fortunately, not everyone suffers from this extreme form of moral hazard: the SKEW index, which reflects the downside tail risk for the S&P 500, reached 146.3 on July 2, more than three standard deviations above the long-run average of 119.7. Put differently, at least some investors think it’s worth insuring against an equity market plunge. Perhaps perversely, this is good news for the Fed; and, for the rest of us, too.
Still, we suspect there are probably many investors who judge that, should financial conditions begin to tighten again, the Fed will look for ways to counter any economic impact. Indeed, policymakers could naturally justify such actions as measures to meet their goals of price stability and maximum sustainable employment.
While we agree that the stabilization benefits currently exceed the moral hazard costs, it is difficult to escape the conclusion that, after having backstopped crisis markets twice in a dozen years, the Fed is now prepared to support virtually every part of the financial system. This leads us to fear that risk will be chronically underpriced, with investors pressuring the Fed to react strongly to even modest downward shocks.