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.

The Fed Goes to War: Part 1

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.

The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.

In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand….

COVID-19: What can monetary policy do?

Two weeks prior to their regularly scheduled mid-March meeting, the members of the Federal Open Market Committee (FOMC) voted unanimously to cut their target policy rate by 50 basis points to the 1 to 1¼ percent range. Policymakers attributed their exceptional decision to the “evolving risks” posed by the coronavirus. This move was the first inter-meeting policy rate shift, and the largest cut, since late 2008, at the depth of the financial crisis. Moreover, this time the move came against the background of a strong economy. Nevertheless, based on futures prices, market participants anticipate a further 75-basis-point cut in the target federal funds rate this month!

The coronavirus has thrust us into uncharted territory. Do central bankers really have any tools to guide us back to safer ground?

In the remainder of this post, we discuss the importance for policymakers of distinguishing between shocks to aggregate supply and demand. Importantly, while monetary policy can combat demand shocks, it can do nothing to cushion the impact of reductions in supply without sacrificing the commitment to price stability. The coronavirus shock involves some as-yet-unknown mix of these two very different types of shocks. Yet, given the limited amount of conventional policy space, and the decline of long-term inflation expectations, there is a good case for the FOMC to act rapidly and aggressively….

Contagion: Bank Runs and COVID-19

There are currently more than 85,000 confirmed cases of COVID-19 in at least 60 countries. Yet, we know very little about this pathogen, except that everyone is worried. And, with the number of cases rising each day, intensifying concerns probably will lead many people to behave in ways that undermine economic activity. They will shy away from places where the virus can be transmitted. That means avoiding mass transit, schools, and workplaces.

Moreover, many people will stay away until they are confident that the disease is manageable. That confidence probably requires an effective treatment, a very low likelihood of infection, or both. Not surprisingly, many observers are reducing their projections for economic growth this year, while financial market participants anticipate easier monetary policy to cushion the shock.

The challenge of re-establishing public confidence that it is safe to venture out bears striking similarity to the one that authorities face in stemming a bank run. Our ability to identify and quarantine people infected with COVID-19 is analogous to our ability to recognize and isolate a bank bordering on insolvency. This and other similarities suggest that the means we use to control bank runs also may be useful in managing the economic consequences of an emerging pandemic like COVID-19….

Bank Runs and Panics: A Primer

A bank promises its clients immediate access to cash. Depositors can redeem their funds on demand at face value—first come, first served. Other short-term creditors can do the same, albeit at varying speeds, by not rolling over their loans. And, households and firms that pay a fee for a credit commitment can take down their loans at will.

For banks that hold illiquid assets, these promises of liquidity on demand are the key source of vulnerability. The same applies to other financial institutions (de facto or shadow banks) that perform bank-like services, using their balance sheets to transform illiquid, longer-maturity, risky assets into liquid, short-maturity, low-risk liabilities.

A bank run occurs when depositors wish to make a large volume of withdrawals all at once. A bank that cannot meet this sudden demand fails. Even solvent banks—those whose assets exceed the value of their liabilities—fail if they cannot convert their assets into cash rapidly enough (and with minimal loss) to satisfy their clients’ demands. A banking panic is the plural of a bank run: when clients run on multiple banks. We call the spread of runs from one bank to others contagion—the same term used to describe the spread of a biological pathogen.

In this primer, we characterize the sources of bank runs and panics, as well as the tools we use to prevent or mitigate them….

Monetary Policy in the Next Recession?

In many advanced countries, lowering the policy rate to zero will be insufficient to counter the next recession. In the United States, for example, with the target range for the federal funds rate at 1½ to 1¾ percent, there is little scope for the nearly 5 percentage-point easing that is typical in recent recessions (see, for example, Kiley).

This is the setting for this year’s report for the U.S. Monetary Policy Forum, written with Michael Feroli, Anil Kashyap and Catherine Mann. Our analysis focuses on the extent to which the “new tools” of monetary policy—including quantitative easing, forward guidance and negative interest rates—have been associated with an improvement of financial conditions. The idea is that the transmission of monetary policy to economic activity and prices works primarily through its effect on a broad array of financial conditions.

The USMPF report does not challenge the views of many researchers and of most central banks that the new monetary policy (NMP) tools have an expansionary impact even at the effective lower bound for nominal interest rates (see also the 2019 report from the Committee on the Global Financial System). However, we find that these new tools generally were not sufficient to overcome the powerful headwinds that prevailed in many advanced economies over the past decade.

Our conclusion is that central bankers should clearly incorporate the new tools in their reaction functions and communications strategies, but should be humble about their likely success in countering the next recession, at least in the absence of other supportive actions (such as fiscal stimulus)….

Some Unpleasant Gold Bug Arithmetic

Most people care far more about the prices of things they purchase—food, housing, health care, and the like—than the price of gold. Not coincidentally, professional economists display a remarkably explicit consensus against forcing the central bank to adopt a policy that fixes the price of gold.

Yet, there are still powerful people who think that the United States would benefit if the central bank’s sole purpose were to restore a gold standard. With the nomination of gold standard advocate Judy Shelton to be a Governor of the Federal Reserve, we feel compelled to take these views seriously. So, here goes.

Several years ago, we emphasized that a gold standard is incredibly unstable. In this post, we address the mechanics of how the U.S. central bank would run the system. In our view, it is incumbent on any gold standard advocate to answer a series of practical questions: What gold price are they proposing? How much gold would the Federal Reserve have to acquire and hold to make the scheme credible? Will the Fed be able to lend to banks and operate as a lender of last resort?

Our answers highlight the operational challenges. Since the Fed initially would commit to holding a particular dollar value (that is, the product of price and quantity) of gold, we need to consider price and quantity together. With the smallest balance sheet we can imagine, our best guess is that the Fed initially would have to triple its gold holdings, driving the price of gold up by two thirds (to about $2,600 per ounce). Then, to maintain the gold standard, the Fed would still need to purchase one-third of world gold production each year. Without gold holdings over and above this minimum, the Fed would not be able to lend at all, much less without limit as it can under a pure fiat money standard….

Has P2P lending already hit the wall?

The two biggest U.S. P2P lenders, Prosper and Lending Club, started operations in 2005 and 2007, respectively. Over the past decade, their business has grown so that they now originate more than $10 billion in loans per year. The public information provided by Lending Club gives us an opportunity to judge how they are doing. At first, P2P lending returns appear remarkably high (adjusted for volatility), but growing evidence of adverse selection highlights how difficult it will be to sustain growth.

When we last wrote about P2P lending, we suggested that profitability might be a consequence of the booming economy (see here and here). We concluded that one would need to see performance in a recession before judging P2P’s long-run potential. That is, when you are making consumer loans, it is relatively easy to make money as the unemployment rate falls from 10% to 3.5%. However, profitability over the course of an entire business cycle, including periods when joblessness is rising, is an entirely different story.

Well, maybe there is no need to wait….

Foreign Exchange Trading: 2019 Edition

Every so often, new data provide us a glimpse of parts of the world that few people ever see. Last week, the BIS’s Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019 provided just such a view. The headline is that average daily foreign exchange (FX) turnover, adjusted for double counting, is $6.6 trillion per day. That is, nearly 8% of global GDP changes hands in FX markets every day! (For a summary, you can listen here.)

Numbers of this magnitude raise a host of questions. In this post, we explore three: first, who is shifting such large volumes of currency around, and what motivates them? Second, history teaches us that disruptions in FX markets can destabilize the broader financial system: are there signs of emerging risks? Finally, what do we learn about the relative position of the U.S. dollar?

To anticipate our conclusions, the fraction of trading involving nonfinancial entities is relatively small, so the bulk of these transactions (like those in most financial markets) are between intermediaries. In addition, there are hints of growing systemic risk in the FX settlement system, so we need to remain attentive. Finally, no other currency is threatening the dominance of the U.S. dollar—at least, not yet….

Monitoring the Monitors

Disclosure is a fundamental pillar of our market-based financial system. When information is accurate and complete, asset prices can reflect both expected return and risk. Yet, having information is one thing; using it appropriately is something else entirely. To evaluate the relative merit of a large number of potential investments, most people (including us) rely on specialists to do the monitoring: Independent auditors vouch for the accuracy of financial statements. Credit rating agencies tell us about the riskiness of bonds. Various brokers and specialized firms rate equities. And, for mutual funds, there are several monitors, of which Morningstar is the most prominent.

But, when the specialists fail to do their jobs, disaster can strike. Examples abound: auditors failed in the case of Enron; equity analysts overvalued technology firms during the dotcom boom; and rating agencies’ inflated assessments of structured debt contributed substantially to the financial crisis of a decade ago (see here). So, there is cause for concern anytime we see evidence that key monitors are falling short.

This brings us to the recent work of Chen, Cohen and Gurun (CCG) on Morningstar’s classification of bond mutual funds. They argue that mutual fund managers are providing inaccurate reports, and that Morningstar is taking them at their word when better information from standard disclosures is readily available. In this post, we describe CCG’s forensic analysis, but we don’t need to postpone our conclusion: if we can’t trust the monitors, then markets will not function properly….

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Money, Banking, and Financial Markets