Following Bagehot – The Fed to the rescue!

Over the past four weeks since the US central bank cut the federal funds rate on 3 March by 0.5% to 1.0-1.25%, the US Federal Reserve (Fed) has moved very quickly through the gears to roll out a series of liquidity enhancing programmes at home and abroad.

In addition, on 15 March the Federal Open Market Committee (FOMC) announced a further cut of 1.0% in the fed funds target to 0-0.25%, effectively the “zero lower bound” since the Fed has repeatedly indicated that they do not wish to embark on a policy of negative interest rates.

Side show

In our view, however, the interest rate cuts are really a side show.

To repeat one of our favourite mantras, “Monetary policy is not about interest rates but about the growth of the broad quantity of money”.

As we have said from the start of this crisis, what will really matter is the quantitative response that the Fed is able to engineer, i.e. how much it expands its balance sheet to ease credit conditions, narrow bid-offer spreads, and generally induce critical domestic funding markets and international swap markets to start operating smoothly again.

Injecting cash by expanding their balance sheets is the classic way that central banks have always calmed a panic.

The classic strategy for how a central bank should react in a crisis was set out by Walter Bagehot in his famous book, “Lombard Street: A Description of the Money Market” in 1873. “A panic,” he wrote, “is a species of neuralgia, and according to the rules of science you must not starve it.

The holders of the cash reserve [in those days, the gold held by the Bank of England] must be ready not only to keep it for their own reserve, but to advance it most freely for the liabilities of others.”

In other words, in a crisis of confidence the central bank should pay out as much cash [gold] or discount as many securities for cash as needed to calm the panic and meet demand.

After the panic has subsided, the excess of funds created to cool the “neuralgia” (by which Bagehot meant a fever) can be withdrawn as life returns to normal.

Following Bagehot, the Fed has therefore reacted in broadly the correct manner to counter the “sudden stop” induced by the coronavirus crisis.

Providing funds for stressed markets

Over the past two weeks it has rolled out a series of programmes to provide funds to numerous troubled markets: the repo market, the US Treasury market, the corporate bond market, the municipal bond market, the commercial paper market, money market funds, the bank loan market, and the international market for US dollars.

In all these markets there was evidence of market breakdown: widening bid-offer spreads, lack of volume, huge price movements and an inability to raise new funds.

The “plumbing” of the financial system was effectively blocked.

Unblocking the pipes

To unblock the pipelines the Fed needed to inject funds into the funding markets - temporarily or on a longer term basis.

The temporary injection is typically done by “repos”; the latter is done by buying securities directly.

In the former, the New York Fed on behalf of the Fed in Washington arranges to purchase securities in exchange for a loan of cash while simultaneously agreeing to sell it back after a set term.

The Fed has been actively doing repos since the spike in market rates last September.

In the latter case, the Fed can buy securities outright and this provides cash to the seller.

Historically the counterparties to these transactions are Primary Dealers and a limited range of other institutions.

Both sets of transactions - repurchases or direct purchases of securities - expand the Fed’s balance sheet as they add securities to its assets, and the reserve accounts of banks on its liability side are credited when the Fed’s “check” (though nowadays all transfers are electronic) is presented for settlement by the seller’s bank.

In both types of transactions the public (dealers, money managers, insurance companies, pension funds or others) receive a deposit of cash which can meet their need for liquidity.

In Bagehot’s phrase, the neuralgia or panic will have been calmed.

Calming measures  

To see how much calming of the markets the Fed has done we have been tracking the daily operations of the Fed.

Figure 1 shows the expansion of the Fed’s balance sheet on a weekly basis since 20 January. Since the onset of the crisis (26 February) the total has grown by US$1.215 trillion to US$5.37 trillion from US$4.16 trillion, or by nearly 30%.

We fully expect the balance sheet to double before the end of the Covid-19 crisis, but the Fed has made a good start.

Figure 2 shows the size of key holdings of assets on the Fed’s balance sheet since late January.

When the crisis erupted at the beginning of March the Fed began by massively increasing the size of the repos that it was willing to offer.

For example, on 20 March, the Fed offered US$1.5 trillion in three auctions of US$500 billion each, but the take-up was only US$55 billion.

Something was wrong: either the dealers did not need cash, or they had no latitude, given the various balance sheet ratios they had to maintain - “no balance sheet” (i.e. capacity) in market jargon - to be able to do the repos in the volume that the broader market was demanding.

Going direct

As a result, over the 21-22 March weekend the Fed decided to “go direct” - i.e. to purchase a whole range of securities in different markets, providing cash directly to those who were willing to sell the securities.

Since then repo operations have been slowing (Figure 2) and purchases of Treasuries have taken over the lead role.

More recently, US$ swaps with foreign central banks have surged from nothing to near equality with repos.

We expect the Fed will need to do substantially more US$ swaps over the next few weeks in order to grease the wheels of international trade and supply chain financing.

The Fed has a special role to play in this “Eurodollar” market, meaning the market for US$ outside the US.

The reason is that global trade and commodity invoicing are largely US$-denominated and the Fed is the ultimate supplier of US$.

MBS purchases continue, but at a relatively slow rate.

The cumulative changes in the Fed’s total assets and the individual components since 26 February are shown in Figure 3.

Conclusion

The Fed’s operations to calm the panic and restore normality have only just started.

It will probably be many months or even years before the Fed can start unwinding these extraordinary operations.

There are two key points to understand here.

1. After the global financial crisis (GFC) the Fed conducted large-scale asset purchases, but these did not produce inflation. On the contrary, for most of the past decade inflation remained sub-target. Similarly, there is no need for the current episode of balance sheet expansion to generate inflation either.
2. During the past five years the Fed has attempted to normalise monetary policy and reduce the size of its balance sheet. For a while it succeeded in returning interest rates to something close to normal levels, but in attempting subsequently to shrink its balance sheet the Fed triggered problems in the repo market last autumn.

The basic reason for both these problems - the inflation undershoot and the failure to shrink its balance sheet - is that after the GFC the Fed and the regulators together curtailed the growth of commercial bank balance sheets to such an extent that broad money growth remained too low for much of the past decade.

The result was mediocre nominal GDP growth, sub-target inflation and persistently low interest rates.

Remember: as Irving Fisher showed, interest rates follow inflation; they do not lead it.

Therefore when the Fed tried to shrink its balance sheet it quickly encountered constraints that would not have existed if commercial banks had been expanding their balance sheets more rapidly - i.e. growing their loan book or buying securities and creating money at a faster rate.

So far Chairman Jay Powell and his team are doing a great job responding to the current crisis, but the real test will only come when, in the months or years to come, they try to exit from the current balance sheet expansion policy.