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Economic Research: The Federal Reserve Performs A Rebalancing Act To Ease Conditions

(Editor's Note: This report updates our article on developments in U.S. monetary policy, titled "The Federal Reserve's Balancing Act," published on Nov. 19, 2019.)

"We are not even thinking about thinking about raising rates," Fed Chairman Jerome Powell said on June 10, 2020.

The primary takeaway from the June Federal Open Market Committee (FOMC) meeting was that the Fed is not moving away from its ultra-easing monetary stance, unless the outlook for the economy changes dramatically, which we think at this point remains unlikely. The Fed is solely focused on one thing at the moment: getting the economy back to full employment, which we project is at least a multiyear process. Rates are staying low, even if the stock market powers forward.

This comes against the backdrop of the COVID-19 recession, which has been unprecedented in scope and speed compared with other downturns since WWII and unique in that it is due to the coronavirus and mitigation measures taken to curb its toll on society (1).

Our belief in the Fed's dovish monetary stance is supported by the following:

  • The FOMC's summary of its economic projections shows a central tendency for the Fed funds rate with no rate hikes until 2022 (and only two of 17 participants projected lift-off in 2022).
  • The FOMC's implementation note directed the New York Federal Reserve to increase the system open market account (SOMA) holdings of Treasury securities and agency mortgage backed securities (MBS) and commercial MBS at least at the current pace.
  • At the press conference after the meeting, Chairman Powell signaled members wouldn't tighten on fears of a stock market bubble and assured that they will maintain zero rates (and use the Fed's policy tools to the fullest extent if needed) until they see the labor market approaching full employment.

Monetary Policy Developments Since February

Since the week of Feb. 26, 2020, when the COVID-19 pandemic became front and center in major economies outside Asia, the FOMC has found itself flexing its crisis management muscles in an unprecedented manner.

The Fed slashed its policy interest rate to zero (see chart 1), launched an unlimited government bond-buying program (by adding to the $2.1 trillion securities held outright already; see chart 2), and announced 11 extraordinary credit-supporting liquidity facilities (both new and old) that have $2.6 trillion earmarked, with the potential to be extended up to $4.5 trillion, in funds to small businesses, companies, and state and local authorities (see table and Appendix 1).

Chart 1


Chart 2


The extraordinary programs put in place have had important effects, even though some programs have yet to launch or build substantial scale. The balances in the alphabet soup of emergency-lending programs stood at $156 billion as of last Thursday (June 11), including positive balances in all but three of 11 programs. The other three programs--the Main Street facilities (MSELF, MSNLF) and the Term Asset-Backed Securities Liquidity Facility (TALF)--have yet to become operational but are expected to do so soon (2).

In many cases, the announcement of Fed support, by itself, has caused conditions in targeted financial sectors to improve, resulting in narrower bid-ask spreads, declines in risk spreads, and more orderly trading in markets for risky assets. Arguably, the Fed effectively signaled its intentions and thus has needed to do fewer market/program operations (3). The effects of the FOMC announcements aside, the tried and tested quantitative easing (QE) and international dollar-swap lines really saved the day.

Federal Reserve Policy Support During COVID-19 (Since Feb. 26, 2020)
Program/facility Abbreviation Targeted sector Purchases, direct lending, or SPV Announced Treasury support (bil. $) Capacity (bil. $) Authorization Significant announcement Added to current balance, as of June 11 (bil. $)
Asset purchases ** --- Treasuries, AMBS Purchases 0 Not stated FOMC Several 2,140.10
Repurchase agreements --- Short-term loans to financial intermediaries Direct loans 0 Not stated FOMC Several 167.30
Discount window --- Banks Direct loans 0 Not stated 10(B)^ 15 March 8.00
Commercial Paper Funding Facility* CPFF Commercial paper SPV 10 Not stated 13(3)§ 17 March 12.80
Primary Dealer Credit Facility PDCF Primary dealers/liquidity Direct loans 0 Not stated 13(3)§ 17 March 5.80
Money Market Mutual Fund Liquidity Facility MMLF Money market mutual funds SPV 10 Not stated, but likely unlimited 13(3)§ 18 March 26.97
Term Asset-Backed Securities Loan Facility TALF Asset-backed securities SPV 10 Up to $100 billion 13(3)§ 23 March 0.00
Central bank swap lines --- Central banks/dollar liquidity Direct loans 0 Not stated 14+ 15 March, 19 March 444.50
FIMA Repo Facility FIMA Foreign monetary /Treasury liquidity Direct loans 0 Not stated FOMC 31 March 0.00
Paycheck Protection Program Liquidity Facility PPPLF Bank loans to small businesses for PPP Direct loans 0 Limited by PPP, $659 billion 13(3)§ 6 April 56.98
Corporate credit facilities PMCCF, SMCCF Corporate debt SPV 75 Up to $750 billion 13(3)§ 23 March 37.37
Main Street Loan Facilities MSELF, MSNLF Small and midsize businesses SPV 75 Up to $600 billion 13(3)§ 23 March, 9 April 0.00
Municipal Liquidity Facility MLF Municipal debt SPV 35 Up to $500 billion 13(3)§ 9 April 16.08
Totals 215 > 2,609 2,915.9
Note: Indented items are similar to analogous programs used to provide support during the 2008–2009 financial crisis. **Asset purchases since 26 February 2020. Total Treasuries plus AMBS stands at $5.99 Trillion as of June 11. §Section 13(3) of the Federal Reserve Act that authorizes emergency lending programs. ^Section 10(B) of the Federal Reserve Act (Advances to Individual Member Banks) describes the operation of the discount window. +Section 14 of the Federal Reserve Act, "Open-Market Operations." Note: The CARES Act authorized the Treasury to provide up to $454 billion in equity investment in the Fed's emergency lending facilities. So far $215 has been earmarked officially, although some of this may be held in reserve in case losses are bigger than expected in some of the programs. SPV--Special purpose vehicle. Sources: The Federal Reserve H.4.1 Statistical Release, IHS Markit, and S&P Global Economics.

As of June 11, the Fed had added $2.95 trillion to bank reserves (at the Fed) via its COVID-19-era QE and other support programs since Feb. 27. This brought total Fed assets up to approximately $7.2 trillion or 36% of nominal GDP, up from 19% at the end of February.

Heavy Lifting Through Aggressive QE

While the extraordinary programs are just beginning to gear up--and it will be some time before the effects on the economy will be fully evident--the "now-conventional" QE has done most of the heavy lifting (4).

About 72% of the $3 trillion increase in the Fed's assets has come through the Fed's QE asset-purchase program of Treasury and agency mortgage-backed securities (AMBS; see chart 3). To get a sense of how aggressive the Fed was: There was a point around the end of March at the height of financial market stress that the Fed was purchasing $75 billion a day in Treasuries.

The relatively forceful nature of current QE by the Fed is also evident in comparison with the past business cycle and the actions of other central banks. From mid-2008 to the end of 2019, the Fed's balance sheet grew by 13% of GDP; in just over the past five months, it grew by more than 17% of GDP and stands currently at little over 36% of GDP (see chart 4). In comparison, the European Central Bank's (ECB) balance sheet grew by 12% (versus over 24% from June 2008 to December 2019); the Bank of Japan (BOJ) by 14% (versus over 85%); and the Swiss National Bank (SNB) by 20% (versus 100%, in an effort to keep their exchange rates from appreciating).

Chart 3


Chart 4


Under QE, the central bank deliberately expands the size of its balance sheet to ease monetary conditions by acquiring assets (usually government debt securities, but in principle any asset) paid for by creating reserves (5). In theory, this process has no limit or, more accurately, the only theoretical limit is the stock of assets in existence (6).

When the New York Fed starts implementing QE, they basically prod primary dealers who are the big banks (marketmakers) to continue making markets (for the Fed)--basically nudging them to purchase bonds, and the Fed gives them reserve deposits by swapping those bonds (7). The Fed will essentially backstop the financial system, reducing the odds of the pandemic turning into a banking panic, which, in turn, would lead businesses to fail en mass, all things equal.

Since late February, the Fed has poured sufficient liquidity into the banking system, as indicated by the doubling of excess reserves at banks (by $1.6 trillion) over the last three months to a total of $3.3 trillion (see chart 5). The Fed dramatically accumulated assets on its balance sheet in order to stave off a liquidity crunch.

Chart 5


Swings in the U.S. government's general account also matters on the level of bank reserves. The U.S. Treasury is sitting on a $1.5 trillion pile of cash currently--ready to be disbursed--with the Treasury's bill issuance outpacing release of the funds. The Treasury has announced a target balance of $800 billion by the end of June, which means if the target is met, this would add to reserve liquidity buffers (by $700 billion) of the banking sector, relieving some of the usual end-of-quarter stress at the margin. (Bank reserves go up when government deposits go down--net government transfers to the public show up in commercial bank deposits.) As reported by Bloomberg, Treasury Secretary Steven Mnuchin said last week that of the roughly $3 trillion of pandemic relief, about $1.6 trillion has been used and "we're busy working on disbursing the rest of the money."

The Fed's actions, together with direct government transfers to households, have resulted in an outsized $2 trillion, or 15% deposit growth, for commercial banks in the U.S. between the end of February and early June, boosting banks' liquidity and helping them meet borrow draws on credit facilities. Further release of deposits from the government's account to nongovernment entities will add to the banking sectors' deposits. In addition, the increase in mortgage activity and asset prices that have likely have resulted from the Fed's policies have also aided banks' fee income. (However, ultra-low interest rates are weighing heavily on banks' net interest margins and should contribute to weakening bank profitability over all.)

What would have happened if the Fed had not embarked on accelerated asset purchases or launched emergency programs? It's not definite what the counterfactual would have been, but the experience of the Great Depression suggests that banks, desperate for liquid assets, would have cut back loans to healthy borrowers much more aggressively, and the money supply would have collapsed.

QE ebbed as conditions improved but will remain in place at its current pace

The pace of securities purchases has declined sharply since late March as conditions in securities markets have improved. The Fed reduced the pace of combined asset purchases of Treasury securities and AMBS to an average of $10 billion per day during the final five business days in May from over $100 billion per day in late March.

Further declines in the pace of Fed asset purchases are not likely in the near term, however (8). The Fed announced that it would continue purchasing Treasury securities and AMBS (both residential and commercial) "at least at the current pace" to promote smooth functioning in securities markets. For the rest of the year, we anticipate that the Fed will maintain, on average, the current (June) pace of $20 billion to $25 billion a week in Treasury purchases and $16 billion to $20 billion of AMBS (9). This means the SOMA assets on the Fed's balance sheet are likely to grow by another $1.0 trillion to $1.2 trillion the rest of the year, from the current $6 trillion. Combined with other programs, total assets are likely to be close to $9 trillion, twice the size they were in February.

The rising share of Treasury debt with the Fed will continue to suppress term premium

The Treasury assets added this year by the Fed would represent about three-fifths of the approximately $4.0 trillion in net Treasury issuance needed to fund the widening budget deficit (10). The share of outstanding marketable Treasury debt in the Fed's holdings rose to 21% in April from 14.6% in February and will likely creep up another 3 percentage points by the end of this year.

Chart 6


Chart 7


Asset purchases have already helped keep a lid on long-term interest rates by suppressing the term premium. A meta-study on the effects of QE by Joseph E. Gagnon and Brian Sack (2018) concludes that asset purchases of 1.5% of GDP is roughly equivalent to a 0.25 percentage point cut in the policy rate.

Using Gagnon and Sacks' estimate, our expectation of 20% of GDP in asset purchases by the end of this year means close to 3.3 percentage points of additional easing on top of a 1.5 percentage point policy rate cut. This additional easing depends on market participants' belief that the Fed will hold these bonds for years to come instead of selling them, and the Fed's purchases are concentrated in bonds with long-term maturity duration. The additional easing effect is likely lower, however, since the Fed isn't strictly buying long-term bonds (10 years or more), and in fact the average maturity of Treasury debt now held by the Fed declined to 7.3 years from 7.7 years in March.

Still, consistent with our expectation of continued QE until the end of the year, the suppressed term premium will likely mean long-term rates increase only moderately as the recovery takes hold, despite a surge in demand for Treasuries, which, all else equal, should place upward pressure on rates. That said, with term premium already low to begin with, the stimulative growth effect might be smaller than in the past.

Threshold-Based Forward Guidance Still To Come

We don't believe the Fed will announce a big policy initiative soon, because officials have signaled that they will wait and see how the economy rebounds from the COVID shock, especially considering that the first wave of workers going back to work pushed the unemployment rate down to 13.3% in May. During his press conference, Chairman Powell steered clear of threshold-based long-term commitments on interest rates, asset purchases, and the trajectory of the Fed's balance sheet, but he reinforced his commitment to supporting the programs in place at least until the recovery is well underway.

Still, if history is any guide, it is only a matter of time before the Fed announces a more concrete outcome-based threshold, promising to keep interest rates at current levels until specific a macroeconomic objective is met, such as the unemployment rate declining to a certain point (11).

The major benefit of forward guidance is that it signals to financial market participants that short-term interest rates will not increase until a certain objective has been met, or a time period has elapsed. This in turn helps keep a lid on intermediate and, to a lesser extent, longer-term interest rates.

Cold On Negative Rates, Warming Up On Yield-Curve Control

Besides indicating they will keep policy on hold for the foreseeable future, the Fed members have so far ruled out negative (nominal) interest rates (NIRP), they but discussed the yield-curve control (YCC)--which was last used in the U.S. during World War II and its immediate aftermath (1942 to 1951) and currently in Japan since September 2016 to hold down bond yields. The Reserve Bank of Australia recently began an experiment targeting three-year bond yields. (YCC is different in one major respect from QE: QE deals in quantities of bonds; YCC focuses on prices of bonds.)


Negative policy rates may seem like a natural continuation of the Fed's QE programs. Under NIRP, financial institutions pay interest to the central bank on the liabilities the central bank issues to them (12). Several central banks have a negative policy interest rate and have done QE, most notably the ECB and the BOJ (13).

Since the effective lower bound (ELB)--which differs from the zero lower bound (ZLB) because of the costly frictions associated with using cash (including storage, transport, and insurance)--is at least slightly negative (no one knows the precise level), we can't rule out entirely the possibility that the Fed will consider negative interest rates in the future, but, thus far, the member's aren't. And for practical reasons, we think.

First, the evidence of NIRP's success in generating growth or inflation is weak. Second, all else equal, negative rates erode the profitability of banks, in turn reducing the resilience of the banking sector, which provides credit in the economy when it is much needed. Third, even the proponents of negative rates point out that, past a certain negative threshold, the policy does more harm than good. That risk likely accounts for why no central bank has yet tried to lower its policy rate even to -1%. The way the policy works is nuanced, but suffice it to say the Fed finds it an unattractive tool.


As for YCC, or sometimes called interest-rate caps, Fed Governor Brainard--in her speech prior to the COVID crisis--made the case for YCC at the short to medium-term maturity range (14). Governor Brainard (and other Fed members) said that the Fed, if it ever adopted some interest-rate peg, would be more successful at targeting near or medium-term rates, such as those that will reach final maturity within one to two years. It's likely to start by pinning the one-year Treasury yield around zero and then extending the pin to two-year yields if more monetary policy support was needed.

Why focus on the short to medium peg, when most historical precedents for YCC involve pegs on long-term rates? This is mainly because any balance-sheet-related policy would have to be consistent with the expectation of the primary overnight borrowing policy rate. A YCC strategy will be sustainable if investors believe that inflation and short-term rates will be low for the duration of the peg. In the U.S., especially with the large and liquid market of U.S. Treasuries, in which investors trade bonds frequently as they update their expectations about policy rates, targeting shorter-term yields would be easier and more likely to be perceived as a credible policy by the public than targeting long-term yields.

Chart 8


The overall idea is to complement forward guidance and QE, two policies that are firmly part of the Fed's toolkit. The interest-rate cap would reinforce forward guidance that the Fed funds rate will be at zero for a particular length of time and, in turn, remove one of the risk factors that could result in spikes in term yields as a recovery gets underway. Meanwhile, QE could put downward pressure on longer-dated assets than those to which the peg applies. In other words, if used in combination, the three policies could simultaneously lower, flatten, and even out the entire Treasury yield curve (see chart 8).

The experience of BOJ with YCC since 2016, when it started to keep the 10-year Japanese Government Bond yield close to zero, has been without any serious damage to the Japanese economy or financial system. In fact, YCC has allowed the BOJ to purchase bonds at a slower pace in the last three and a half years compared with 2013-2016 period under its large QE program and still keep yields on 10-year bonds at historically low levels. So moving to a price target from a quantity target might not be a bad thing if we think central bank holding of government bonds is an issue.

Like other unconventional monetary policies, a major risk associated with yield-curve policies is that they put the central bank's credibility on the line. With YCC, the central bank essentially becomes the residual buyer of these government bonds in the secondary market, and, as a result, the change in the size of the Fed's balance sheet would depend on a combination of the Treasury's debt management decision and the willingness of private investors to hold the Treasury at the specified yield cap. This comes perilously close to monetary financing and has some flavor of helicopter money, or direct central bank financing of the economy (15).

For Inflation, The Size of Fed's Balance Sheet Is Not A Major Threat…

Some observers have argued that the massive expansion in reserves as a result of QE will lead to uncontrolled inflation. This is a monetarist argument that holds two beliefs: controlling money growth is necessary and sufficient to control inflation, and, outside of a financial crisis, the monetary base--the sum of bank reserves at the Fed and currency in circulation--determines the quantity of money (16). Putting the two together, the argument is, basically, that when the central bank's balance sheet grows quickly, inflation inevitably follows. We don't believe this view is borne out by data.

For the increase in reserves to lead to uncontrolled inflation, at least two relationships would have to hold. First, changes in the monetary base (reserves plus currency in circulation) would have to determine changes in the quantity of money. Second, changes in money would have to influence prices. It turns out that neither relationship is stable (see charts 9 and 10). In fact, at low levels, inflation appears to be unrelated with growth in money supply.

Chart 9


Chart 10


Besides, there is also no relationship between the size of the Federal Reserve's balance sheet and long-run inflation expectations derived from financial markets during last 10 years of balance-sheet expansion (see chart 11). In fact, the contours of financial-market-based inflation expectations appear to have mirrored the changes in oil prices. Our estimates suggest monthly oil price moves explained only 10% of the variance in U.S. five-year inflation expectations from January 2003 to August 2008 but around 68% of the moves from September 2008 to June 2019. And markets clearly do not foresee oil prices rising much above $50 to $60 a barrel (West Texas Intermediate) in the next couple of years given supply and demand dynamics. The challenge today is not that inflation expectations are too high compared with the Fed's target of 2%, but that they are too low.

The pass-through of expanded QE to the real economy is curtailed by a low money multiplier (the ratio of money supply to monetary base)--i.e. the willingness and ability of private banks to transform the central bank's base money into the transactions that households and businesses routinely use (i.e. loans, etc.). Rather, the rise in nonhousehold credit, reflecting the strategic use of funds for cash flow preservation by corporations and loan-loss provisions by banks (and not new investment), combined with tighter conditions (both supply and demand) for consumer credit during this uncertain environment makes us sanguine about inflation pressure from the monetary channel (17).

Chart 11


While the impact of broad money growth on consumer prices has been weak, the purchasing power created by QE has led to inflation in financial assets. QE works through creating easier financial conditions, including leading investors to stretch for yield. This has led to rich asset valuations. The trick for the Fed and central banks around the world is to create a virtuous feedback loop between these asset price effects and economic activity, so asset prices that might look stretched to begin with help to bring about subsequent increases in economic activity that help to justify them as the economy evolves.

…Nor Is The Surge In Government Spending During The COVID-19 Recession

The federal budget deficit is poised to reach high teens, its highest level since World War II (about 30% in 1943) and much larger compared with 10% during greater financial crisis. Some fear that this will produce excess demand, which will bring higher inflation (18). This view compares our current situation to the post-WWII recovery, when there was massive capital rebuilding underway.

The current increase in fiscal spending, however, is mostly to alleviate the impact of the sudden stop in demand due to the virus, rather than to stimulate the economy. In fact, fiscal multipliers are capped by lingering fears of the virus and the social distancing policies in place. Programs such as PPP will provide a bridge to recovery, as most measures are temporary and will decline in tandem with economic recovery. In the near to medium term, the private sector will likely remain cautious and will rebuild its balance sheet instead of invest in major capital expenditures like it did post WWII.

Chart 12


The Disinflationary Impulse In The Real Economy

To examine inflation dynamics, rather than the monetary channel, we find it useful to look at the breakdown of core inflation into procyclical (categories that are sensitive to the overall business cycle) and acyclical (categories that are sensitive to industry-specific factors) spending.

Pre-virus, we had forecasted inflation to start consistently hitting the Fed's 2% target by the spring of 2020, with the breakdown highlighting upside risks to that inflation outlook (see "What's Next On The Path For U.S. Inflation And Monetary Policy?," published July 31, 2019). Clearly, with the virus and sudden stop in spending, that is no longer the case. The latest data for April shows both procyclical and acyclical spending subcomponents have been affected in a disinflationary manner (see chart 13). The sudden stop nature of the recession is clearly evident in the drop in prices in the acyclical factors.

Chart 13


The procyclical components indicate the risk of disinflation, because the cyclical components that are exposed directly to the virus and suffer from negative demand--such as food services, accommodation, recreation services, and other services--make up half of the procyclical components. Limited pricing power and soft final demand will mean businesses have little ability to raise prices. Compressed profits also mean little room for higher wages, thus limiting the prospects of an already weak wage-inflation dynamic.

At the same time, the sudden stop nature of overall demand, including acyclical spending components--such as health care, clothing, cars, and transportation services--should reverse in activity as the economy recovers, but inflation in this subcomponent is highly unlikely to outpace its past cycle averages. And, while some pockets of stronger goods price inflation may appear as supply chains gradually resume normal operations, these will be partially mitigated by an inventory drawdown--motor vehicles is a prime example--as well as limited pricing power.

All that said, we believe that, with estimated output gap so large and r* (the natural rate of interest that supports full employment economy while keeping inflation steady at target) so low, a temporarily large increase in the fiscal deficit or the size of the Fed's balance sheet leading to an inflationary spiral is not likely. Still, there is always a small chance of inflation, as Olivier Blanchard notes, especially if the U.S. government commands the issuance of Federal Reserve liabilities to meet its funding needs--a case of fiscal dominance (19).

Related Research

  • An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020
  • The Federal Reserve's Balancing Act, Nov. 19, 2019
  • Helicopter Money And The Monetary Garden Of Eden, May. 4, 2016
  • Negative Interest Rates: Why Central Banks Can Defy "Time Preference", Feb. 3, 2016
  • A QE Q&A: Everything You Ever Wanted To Know About Quantitative Easing, Aug. 7, 2014

Appendix 1: The Fed's Monetary Stance During The Current Crisis

As the lender and marketmaker of last resort, the Federal Reserve announced several aggressive monetary policies to facilitate the flow of credit in the economy since the end of February. The Fed's response so far falls into five broad buckets (20). The Fed,

  • Rapidly cut rates to effective zero bound;
  • Started QE infinity, purchasing outright an unlimited number of Treasuries and agency mortgage-backed securities to restore functionality in these critical markets;
  • Put in place liquidity and funding measures--both new programs and extensions of policies during the global financial crisis but on a grander scale--including a discount window, expanded swap lines with foreign central banks, and several facilities with Treasury backing to support smooth functioning in money markets (21);
  • Initiated facilities of direct credit support to households, businesses, and state and local governments with additional backing from the Treasury;
  • Adjusted regulatory requirements (temporarily) to encourage and allow banks to expand their balance sheets to support their household and business customers.

The first eight facilities (see table) are consistent with the Fed's traditional crisis role as a lender and marketmaker of last resort. These simply revive programs from the financial crisis. The Primary Dealer Credit Facility (PDCF) and Money Mutual Fund Liquidity Facility (MMLF) provide loans to financial intermediaries. While the Commercial Paper Funding Facility (CPFF) and Term Asset-Backed Securities Facility (TALF) likely will provide some support to nonfinancial firms, it will remain relatively small. Demand for short-term loans from the Fed through its repurchase facility has diminished as liquidity has become more abundant. Repo loans outstanding declined to $211 billion as of June 4 from $442 billion on March 18.

International dollar-finding operations through central bank swap lines have been more far-reaching during the COVID-19 pandemic than during the global financial crisis, although their actual volume was smaller. While the size of the U.S. dollar swap lines was increased and their conditions made more favorable, the overall usage peaked at $450 billion compared with $580 billion during the financial crisis.

The Paycheck Protection Program Lending Facility (PPPLF) is new, but it does not involve the Fed taking on credit risk. The U.S. government is guaranteeing all of the loans of the Small Business Administration's PPP program. The remaining five programs all involve a very large allocation of credit to nonfinancial entities: the Primary and Secondary Market Corporate Credit Facility (PMCCF and SMCCP), the Municipal Liquidity Facility (MLF), and the Main Street New and Expanded Loan Facilities (MSNLF and MSELF).

Appendix 2: Dollar Lender Of Last Resort For The Entire World

The Fed also worked out expanded dollar-swap lines to counter dollar shortages in key advanced economy central banks throughout the world (see chart 14) (22). The Fed's U.S. dollar standing swap lines with a number of other central banks were important to helping foreign banks continue to provide credit in the U.S. through their U.S. branches, in addition to smoothing strains in global dollar funding markets (23). These lines also created temporary liquidity--the Foreign and International Monetary Authority (FIMA) repurchase facility--that these monetary authorities can draw from to borrow U.S. dollars from the Fed.

Chart 14


Chart 15


The Federal Reserve is the dollar lender of last resort, not just for the U.S., but for the entire world. The U.S. dollar financial system outside of the U.S. is larger than the U.S. banking system, and in a world of massive flows of capital across borders, dollar funding shortages anywhere in the world will spill back into the U.S. through fire sales of dollar assets, a surge in the value of the dollar, increased domestic funding costs, or all three (24). Put differently, when there is a run on dollar liabilities outside the country it poses a clear threat inside the country.

The balance at the major central banks' foreign exchange swap lines with the Federal Reserve as of June 4 was $447 billion outstanding, up from $45 million three months prior, with 82% of total borrowing from the BOJ and the ECB (down from 90% of the total in the last two weeks of March).

The dollar funding shortage in March has since subsided as conditions in the financial market have improved materially. The Fed's FIMA repurchase facility that allows official accountholders to use their Treasury securities held in custody at the New York Fed to obtain dollars has also remained virtually untouched, suggesting improved dollar market functioning.


(1) This is what we call a "pure" exogenous shock leading to a recession, versus a run of the mill recession from an endogenous profit-cycle deterioration.

(2) Just last week, the Fed also widened its Main Street Lending Program by raising the maximum loan size, lowering the minimum business size, extending the term to five years (from four), and deferring principal payments for two years (up from one). The idea is to get more main street businesses to participate in order to minimize solvency issues.

(3) This is often referred to as the "announcement effect"--the psychological impact on the public's expectations about the future course of the Fed's actions. Arguably, the announcement effect has been in full display during the last two months.

(4) QE, the purposeful expansion by a central bank of its balance sheet beyond its normal size by acquiring assets financed by creating excess reserves, can be viewed variously as: what central banks do at the zero interest rate bound; a central bank-engineered asset swap that changes the composition of the aggregate portfolio held by the public; or a debt management/refinancing operation of the consolidated government.

(5) Reserves, sometimes called "central bank money" (not to be confused with foreign-exchange reserves, which sometimes make an appearance on the asset side), are the deposits at the central bank of banks and other financial institutions that maintain an account with it. The interest rate that the central bank sets on reserves anchors and influences the whole of the term structure of interest rates.

(6) There are, of course, legal limits on what assets the central bank can buy. Consider the Federal Reserve. The Federal Reserve Act authorizes the Fed, as part of its open-market operations aimed at achieving its monetary policy objectives, to purchase debt securities issued by the U.S. or any foreign government. So, in principle, if the Fed faced a serious threat of deflation, it could proceed to purchase all government debt in existence, regardless of currency denomination. In normal times, banks are not reserve constrained. The central bank always supplies enough reserves to the banking system, and transactions in the interbank market ensure that reserves are distributed around the system to the banks that need them at any point in time. However, in times of financial distress, like this spring, when counterparty risk is high, this changes. Banks with excess reserves may be unwilling to lend them to banks with too few reserves (to meet minimum reserve requirements, or to meet unexpected withdrawals of deposits, or to roll over short-term funding), or to other banks, full stop. Then the central bank needs to supply reserves directly to the banks that need them, and, anticipating a possible future fall in liabilities, those banks may demand a level of reserves far in excess of regulatory mandated thresholds. (P. Sheard, 2014, "A QE Q&A: Everything You Ever Wanted To Know About Quantitative Easing")

(7) The reserves that the central bank creates, conditional on the impact of bank notes and government deposits, have to be held by the banks in aggregate. (Individual banks of course may borrow and lend those reserves among themselves.)

(8) The New York Fed's announcement for June 8-June 12 indicates $4 billion per day, on average, purchases of Treasuries.

(9) The AMBS amounts are in addition to reinvestment of proceeds from payments on existing securities in the Fed's portfolio.


(11) Alternatively, forward guidance could be time-based, with policymakers agreeing not to raise the fed funds rate until at least a specific amount of time had passed.

(12) Under negative interest rates, financial institutions pay interest to the central bank on the liabilities the central bank issues to them--i.e. the interest rate the central bank applied to reserves. In practice, most central banks that impose negative rates only impose the lowest (headline) rate on a fraction of bank reserves. That is, they practice "tiering" to diminish the impact on bank profits. For example, the BOJ pays a positive rate on a base level of reserves, a zero rate on an amount that increases with the total level outstanding, and a negative rate only on the marginal reserve holdings. Similarly, in September 2019, the ECB adopted a two-tier system that exempts part of excess reserve holdings from the negative deposit facility rate. Could banks "pass on" the negative interest rate on reserves to its depositors? They could try, but there is a limit. Depositors, up to a point, might be prepared to pay a fee for the service of a bank account, just as credit card holders are prepared to pay fees for the convenience of having credit cards. But the ability of depositors to turn deposits into cash and the time value of money together place serious constraints on banks' ability to charge a negative interest rate to depositors.

(13) Central banks that have already applied negative rates are elsewhere are Sweden, Denmark, and Switzerland.


(15) Helicopter money is direct central bank financing of government expenditure. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank's balance sheet. This is monetary finance arising from fiscal dominance: To increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank). With helicopter money, the central bank receives bonds directly from the government, having been obliged to purchase them in the primary market at the behest of the fiscal authority. Furthermore, the government determines the scale of the helicopter money drop, not the central bank. By contrast, in the case of QE, the central bank determines the quantity of assets to acquire and buys them in the secondary market. In doing so, it maintains control over the size of its balance sheet. The latter is the act of an independent central bank; the former is not. (Cecchetti & Schoenholtz, 2020)

(16) This is within the context of Milton Friedman's theory: "Inflation is always and everywhere a monetary phenomenon."

(17) Alongside Fed credit programs, bank lending has risen sharply since late February. Commercial banks have stepped up their lending activity since the crisis began, with almost all of the increase--of some $680 billion--in non-real-estate business loans. Loan volumes rose in March as businesses drew on existing lines of credit and took out new loans and later as banks extended loans for the PPP program.

(18) for historical data on fiscal deficit going back to 1789.

(19) High inflation is unlikely but not impossible in advanced economies. Blanchard believes that three elements must combine for a spiraling inflation outcome: (i) a very large increase in debt-to-GDP ratio, larger than the 20%-30% or so under current forecasts, (ii) a very large increase in the neutral rate of interest, that is, the safe real rate needed to keep the economy at potential, and (iii) fiscal dominance of monetary policy.


(21) (i) buying corporate bonds from the issuers (primary market corporate credit facility, or PMCCF), (ii) buying commercial paper from the issuer (commercial paper funding facility, or CPFF), (iii) funding backstop for asset-backed securities (term asset-backed securities loan facility, or TALF), (iv) buying corporate bonds and bond exchange-traded funds in the secondary market (secondary market corporate credit facility, or SMCCF), and (v) main street business lending program (MSBLP), with details yet to come, but lending to eligible small and midsize businesses, complementing efforts by the Small Business Association.

(22) The provision of swap lines, initially in December 2007 with four foreign central banks, eventually expanded to include 14 "friends of the Fed" (the People's Bank of China a notable exception), while outstanding dollar loans peaked in December 2008 at nearly $600 billion. Since then, the Fed has maintained standing arrangements with five central banks: the Bank of Canada, the Bank of England, the ECB, the BOJ, and the Swiss National Bank. These five facilities are unlimited in scale. On March 19, 2020, the Fed added volume-limited swap facilities for the nine other central banks (for at least six months) that had previously received this privilege during the crisis of 2007-2009.


(24) The Bank for International Settlements reports that short-term U.S. dollar liabilities of non-U.S. banks total $15 trillion. Gross notional value of foreign exchange forward contracts and swaps of over $81 trillion (in the first half of 2019) add substantially to U.S. dollar exposures. While most of the dollar liabilities are issued by banks in Europe, official dollar reserves that roughly match non-U.S. bank liabilities are issued by banks in Europe. This is a bit of distribution mismatch problem. And the U.S. Treasury reports that $6.8 trillion Treasury securities were held by foreigners. In comparison, the total assets of U.S. depository institutions are near $20 trillion currently.

The views expressed here are the independent opinions of S&P Global's economics group, which is separate from, but provides forecasts and other input to, S&P Global Ratings' analysts. The economic views herein may be incorporated into S&P Global Ratings' credit ratings; however, credit ratings are determined and assigned by ratings committees, exercising analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.

U.S. Senior Economist:Satyam Panday, New York + 1 (212) 438 6009;
U.S. Chief Economist:Beth Ann Bovino, New York (1) 212-438-1652;
Secondary Contact:Brendan Browne, CFA, New York (1) 212-438-7399;

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