What fiscal and monetary responses are needed in the US to combat the Covid-19 crisis?

In recent weeks markets have been plunging, impeded by low volumes, lack of liquidity and huge uncertainties about the future outlook for the progress of the health crisis, the economy and the energy market.

Leaving aside the health crisis, which must be resolved as early as possible in order for markets to see light at the end of the tunnel, there are some key counter-measures that need to be taken by the fiscal and monetary authorities to stabilise the financial and economic system.

In contrast to 2008-09 global financial crisis, this downturn, triggered by the coronavirus, is now being deliberately engineered by governments in their efforts to suppress the virus.

Social distancing, self-isolation and the effective shutdown of a vast number of firms and sectors are having a devastating effect on economic activity.

But this is surely the right priority.

Until there are clear signs that the virus has been overcome or at least is on the way to being suppressed there can be little hope of a recovery.

When that happens, the recovery can be reasonably vigorous - provided the authorities take the right measures in the meantime.

What is required?

At the level of general principle, the entire fiscal and monetary toolkit needs to be deployed.

On the fiscal front, two key measures are needed.

1. The government must substantially replace the lost cash flow of businesses and individuals. For example, in the UK the Chancellor of the Exchequer promised something close to 80% income support for most employees, although the self-employed have not yet been covered.
2. There will need to be compensation on a wide scale to businesses and the self-employed for the losses from the government-mandated shutdowns. Government, in short, needs to become the “purchaser of last resort”.

The collapse of economic activity and the need to implement these types of unprecedented interventions on a national and international basis means that governments will need to borrow massive amounts - whatever is necessary - to overcome first the pandemic, and second, enable economies, businesses and individuals to survive financially until a recovery begins.

Governments have done this before in wartime; now they need to do it in the war against the coronavirus.

In the meantime it is probably not very meaningful or helpful to try to make short-term economic forecasts.

On the financial and monetary front there had been clear signs last week that markets were not functioning efficiently, with wide spreads opening up, little trading volume and panic selling of securities at huge discounts to raise funds.

The purposes of these distress sales varied - for mutual funds to meet redemptions, for businesses to pay wages, for payment of rent, to pay interest on loans, to pay suppliers, and so on.

The only entity that could conceivably solve this problem in the short run is the US Federal Reserve (Fed).

It was endowed from the outset with substantial powers to operate in markets to normalise financial conditions.

When it was founded in 1913 one of the fundamental purposes was to provide “an elastic currency” - in other words, to be able to counter the monetary and credit squeeze that had occurred in 1907.

This is exactly the situation today - a flight from risk assets and a credit squeeze - so the Fed needs to deploy these powers in the classic way to the maximum extent needed.

Yet last week the Fed was finding that despite offering huge amounts of cash in the form of repos, take-up at its auctions was pitifully small.  

For example, despite offering US$1.5 trillion in repos via three separate auctions on 20 March, take-up for the day was only US$55 billion.

The cash was not getting where it was needed.

In response the Fed decided to “go direct” - that is, instead of waiting for market participants to find appropriate collateral, register it with the New York Fed and then make the funds available, the Fed had decided to purchase securities directly, thereby injecting funds directly into the financial markets.

Consequently, in addition to the repos it purchased on 20 March, it also purchased US$72 billion of Treasuries and US$36 billion of mortgage-backed securities (MBS), for a combined total of US$163 billion.

But even this was not enough to stabilise the markets.

Over the 21-22 March weekend the Fed therefore decided to act on an even larger scale.

Before the US markets opened on 23 March it announced a breath-taking programme of new measures.

These are designed to ensure the effective transmission of credit to the markets where it is needed in response to the breakdown of market mechanisms and the lack of liquidity precipitated by the Covid-19 outbreak.

In effect, the Fed is becoming the “dealer of last resort”.

Summary of Fed action

The following is a summary of recent announcements from the Fed outlining the new support for the flow of credit to the US economy:

• The Fed will purchase Treasury securities and Agency MBS in the amounts needed “to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.” Any limits to purchases of such assets have therefore been removed. The Fed had previously announced it would purchase at least US$500 billion of Treasury securities and at least US$200 billion of MBS. Going forward, purchases of MBS will also include purchases of commercial mortgaged-back securities (CMBS). Those limits are now abandoned.
• The Fed will create, re-introduce or extend three new lending facilities as follows:

1. The Primary Market Corporate Credit Facility (PMCCF), which will allow companies to issue bonds and sell them directly to the Fed in order to maintain business activity throughout the Covid-19 pandemic. The securities must be investment grade and the term can be up to four years. Under certain circumstances, borrowers may elect to defer interest and principal repayments to ease cash flow constraints on companies (e.g. in order to pay employees and suppliers). In other words, this is free money from the Fed for six months - a kind of bridging loan.
2. The Secondary Market Corporate Credit Facility (SMCCF), which will boost liquidity in the secondary market for corporate bonds. Again, eligible securities must be investment grade. The Fed will make these purchases of debt securities in secondary markets, but in addition for the first time the Fed will follow the Bank of Japan and buy some corporate debt in the form of US-listed exchange traded funds (ETFs).
3. The Term Asset-Backed Securities Loan Facility (TALF), which will lend (on a non-recourse basis i.e. the lender can only claim against the collateral, not against other assets of the business) to holders of certain AAA- asset-backed securities (ABS). The ABS will be used as collateral, and loans will be subject to a haircut. The ABS are generally backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets.

• To fund these three programmes the Fed will create a special purpose vehicle (SPV) to provide up to US$300 billion. The establishment of this SPV is under the authority of section 13(3) of the Federal Reserve Act, with approval from the Treasury Secretary. Using the Exchange Stabilisation Fund (ESF), the Department of the Treasury will provide US$30 billion in “equity capital” to the newly created SPV. In essence, this is the way the Treasury indemnifies the Fed against any loss. If US$300 billion seems a relatively small amount, it should be noted that there is currently a bill being scrutinised by Congress to raise the amount in the ESF to US$425 billion. Using the same “equity” to loan ratio 10 to 1, this could theoretically increase the flow of new credit to US$4.25 trillion.
• In the near future, the Fed expects to announce a Main Street Business Lending Programme, which intends to support lending to small and medium-sized businesses.

Earlier Fed action

Other actions that the Fed had either already taken in the previous two weeks (March 9-20) or extended are as follows:

1. The establishment of three other facilities, whose aim is to boost lending and liquidity. These are the Commercial Paper Funding Facility (CPFF), the Money Market Mutual Fund Liquidity facility (MMLF), and the Primary Dealer Credit Facility (PDCF). Importantly, the remit of these programmes has also increased. Eligible securities for the MMLF will now also include municipal variable rate demand notes (VRDNs) and bank certificates of deposits, in an attempt to alleviate credit conditions in the municipal bond markets. Eligible securities for the CPFF now include high-quality tax-exempt commercial paper, further easing credit conditions for municipals.
2. The re-opening and expansion of US$ swap lines with Japan, the UK, the European Central Bank, Canada and Switzerland, and their extension to other countries for which swap lines were not previously available, such as Brazil, Mexico, Australia, South Korea, Singapore, Sweden, Denmark, Norway, and New Zealand.
3. Cutting the Fed Funds target rate to the zero-lower bound.
4. The elimination of reserve requirements.
5. Providing guidance to lenders to be “flexible with customers experiencing financial challenges related to the coronavirus and to utilise their liquidity and capital buffers in doing so”.

Conclusion

Whether these programmes will be enough to stabilise financial markets is probably open to doubt in the short term.

Far more important will be the progress made in dealing with the virus.

Only once the virus is conquered will these programmes start to generate a recovery.

In the meantime, they will at least ensure that credit can flow and businesses need not fail on a massive scale.

Unprecedented times require unprecedented actions.

On 23 March, the Fed has launched such a plan of action.

We must all hope that the government and the Trump administration are equal to the task in solving first the health problem and simultaneously addressing the urgent fiscal requirements.