Policymakers: Pulling Out All The Stops

In the face of the most serious global health crisis in more than a century, fiscal and monetary policymakers around the world will very likely have to pull out all the stops in an effort to prevent what currently looks like an inevitable recession from turning into a depression, and to stop financial markets from shifting from a drawdown into a meltdown.

The (relatively) good news is that governments and central banks are on the case and have started to respond more forcefully to coronavirus-related stresses this past week. Importantly, seeking to underpin markets and ultimately the economy, the Federal Reserve on Sunday (15 March) ­announced a comprehensive easing package including near-zero policy rates, large-scale purchases of U.S. Treasuries and mortgage-backed securities (MBS), lower rates on currency swaps, and regulatory relief for banks. 

This is about as close as it gets to “whatever it takes.”

Still, a global recession in response to a combination of supply disruptions and a sudden and drastic drop in demand for (mostly) services appears to be a foregone conclusion. Against this backdrop, the task at hand for governments and central banks has been and continues to be to ensure that the recession stays relatively short-lived and doesn’t morph into an economic depression – loosely defined as a combination of a prolonged slump in activity that lasts longer than just a few quarters, a very significant rise in unemployment, and mass business bankruptcies and bank failures.

First and foremost, averting this outcome will require a very large fiscal response to support individuals and businesses that are adversely affected by the crisis. Such a response is now underway in many countries. Tax relief, transfers to individuals, and subsidies to firms will increase current budget deficits significantly. Moreover, government guarantees for bank loans to companies (as announced by several European governments over the past few days) will increase implicit government liabilities and may lead to higher future deficits in the case of losses. Thus, one consequence of this crisis will likely be (even) higher levels of public sector debt in the future.

With real and in many cases even nominal sovereign bond yields negative across most advanced economies, higher government debt levels should be manageable. However, central banks will have an important role to play in ensuring that borrowing costs remain low in the foreseeable future, so that governments can do whatever it takes to overcome both the health and the economic crises. Over the past few days, the European Central Bank (ECB), the Bank of England, the Bank of Canada, the Fed, and many others did just that.

We expect another consequence of the crisis will be that monetary policy will be increasingly dominated by fiscal considerations – a trend that has been underway for some time already and is now likely to accelerate further. Note that such fiscal-monetary coordination is not necessarily bad. In fact, it is exactly what is needed at a time of crisis when the conventional tools of monetary policy are largely exhausted.

Apart from facilitating more expansionary fiscal policy, central banks will also have to ensure that credit can continue to flow to companies and households. This requires regulatory relief for banks that lend to risky borrowers, cheap and ample liquidity for banks, and targeted lending programs for nonfinancial borrowers either via the banks or directly from central bank balance sheets, with or without an indemnity by governments.

Several such measures have already been announced by central banks, for example by the ECB and the Bank of England this past week and by the Fed on Sunday. More is likely to come from the Fed soon, potentially as early as this week, in the form of targeted lending programs under Section 13 (3) of the Federal Reserve Act.

Also encouraging, the Fed’s actions announced Sunday should help restore an orderly functioning of the very core of the U.S. financial markets: the Treasury market and the U.S. mortgage market.

• As my colleagues Rick Chan and Tiffany Wilding explained in a recent blog piece, liquidity in the usually highly liquid U.S. Treasury market was stressed over the past week due to the attempts by leveraged investors to unwind certain trading strategies, which involved selling (or attempting to sell) large amounts of Treasuries at a time when primary dealers are operating with severe balance sheet constraints and under challenging working conditions due to business continuity measures. The New York Fed’s resumption of Treasury purchases late last week was a first step to help alleviate the strains. The Fed’s announcement Sunday that it will buy at least an additional $500 billion of Treasuries should over time help restore the liquidity and the smooth functioning of the Treasury market.
• Moreover, the Fed’s announcement that it will stop running down its holdings of mortgage-backed securities and buy at least $200 billion of agency MBS should go a long way in making the transmission of monetary policy to borrowers more effective. As my colleagues Mike Cudzil and Dan Hyman discussed in a blog piece two weeks ago, the fact that the Fed had continued running off the mortgages on its balance sheet likely had contributed to a widening of the spread between agency MBS and Treasury yields, thus preventing a full transmission of lower rates to mortgage borrowers.
  

All said, policymakers including the Fed are in the process of pulling out all the stops as they try to mitigate the severe economic and financial disruptions caused by the most severe global health crisis in more than a century. More action will be needed and will likely be forthcoming over the next few weeks and months.

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