This time monetary policy is not the cure!

In the COVID-19 crisis, financial markets have full confidence to the Fed. Yet, this time is different.

In the absence of the fiscal support after 2011, the Fed's asset purchase programs made a significant impact on boosting expenditure.

Yet, this time, both short- and long-term interest rates are already low. Since the interest rate incentive is weak, both asset purchase programs and forward guidance will have weaker effects on expenditure.

Assisted by fiscal policy, macroprudential policy can also help the economy raise expenditure and stop contraction through the credit channel.

In the COVID-19 crisis, financial markets show full confidence to the Fed. Yet, this time is different. The Fed itself announces that the monetary policy is desperate. COVID-19 can be overcome through fiscal expansion or macroprudential measures.

In the 2008 global financial crisis, Federal Reserve played a crucial role in fixing the economy. When democrats lost majority in legislation in 2010 midterm elections, fiscal policy could not expand anymore. Conventional monetary tools had also been exhausted since short-term interest rates were close to the zero lower bound. In such a situation, the Fed implemented quantitative easing which aimed at lowering the spread between the short-term and long-term interest rates. Until 2010, the Fed balance sheet had already doubled approximately from 1 trillion to 2 trillion dollars. Between 2010-2015, asset purchase programs more than redoubled the balance sheet from around 2 trillion dollars to 4.5 trillion dollars (The Fed, 2012).

In the face of the global financial crisis, the interest rate gap between the US treasury bills and the riskier assets became wider which disabled businesses to issue asset backed securities (ABS) and households to borrow mortgage loans. Buying large amounts of mortgage backed securities; the Fed increased the demand and thus lowered mortgage rates. The same mechanism worked indirectly for the rest of the long-term ABS market. When the Fed bought large quantities of long-term treasuries, investors had no choice other than investing riskier ABSs. Thus, demand for the ABSs climbed back and closed the spread between the treasuries and ABSs. In the absence of the fiscal support after 2011, the Fed asset purchase programs made significant and positive macroeconomic effects (Hesse et. al. 2017).

Against the COVID-19 shock, the Fed similarly buys large amounts of assets. The Fed's asset purchase programs help interest rates of corporate securities remain low. Yet, this time, both short- and long-term interest rates are already low. The 10-year US treasury yields around 1%. Due to the weak real interest rate stimulus, both asset purchase programs and forward guidance will have weaker effects on expenditure. With a slumped demand, businesses cannot raise their revenues to meet expenses. As a result, massive shutdowns further dampens expenditure causing more lay offs.

The situation will get worse as the economy is stuck in a recession. When investors avoid riskier assets and instead prefer negative-rated US treasuries, the Fed will need to buy more corporate securities to keep markets liquid. As long as the treasury guarantees losses from asset purchase programs, the Fed can continue to asset purchase programs. The Treasury will need an additional Congress authorization of guarantees as the monetary expansion grows.

Chair of the Fed, Jerome Powel pointed at the fiscal policy for recovery. Assisted by the fiscal policy, the macroprudential policy can also help the economy raise expenditure and stop contraction through credit channel. Macroprudential authorities can force banks to expand credits to households and firms. Thus, firms are kept alive, job losses are minimized and consumption is fostered. Yet, beforehand, fiscal authorities may need to inject capital into the financial agencies that are at the edge of their leverage permits.

References

Hesse, Henning, Boris Hofmann, and James Weber. 2017. Effects of Asset Purchases Revisited. BIS Working Papers, No. 680. Accessed 19 November 2018. https://www.bis.org/publ/work680.pdf

The Federal Reserve System. 2012. ‘Recent Balancesheet Trends’ Accessed 15 November 2018. https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

The US News. 2010. 2010 Election Poll Roundup: Obama Approval Rating Hits a New Low. Accessed November 19, 2018. https://www.usnews.com/news/articles/2010/10/21/2010-election-poll-roundup-obama-approval-rating-hits-a-new-low