Monday, April 6, 2020

Explaining the Federal Reserve’s Coronavirus Policy Response Part 2: Domestic Liquidity

Click here to read the original Cautious Optimism Facebook post with comments

4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff moves forward to the Federal Reserve’s specific policy programs to counter the rapid coronavirus economic downturn.

Overall system reserves rise sharply in March of 2020
Note: This installment applies central bank vocabulary and operations mechanisms previously defined in Part 1 of this series. Readers who are not familiar with monetary theory and central banking terminology can find a primer in Part 1 at:

Also, this article is not a full endorsement of Federal Reserve policy by the Economics Correspondent, only an explanation of the Fed’s recent liquidity operations and strategic policy objectives countering today’s unprecedented economic shutdown.


As it becomes clearer to U.S. financial institutions, companies, and households that a sharp recession and economic uncertainty are coming fast, everyone is naturally trying to bolster their dollar holdings as a cushion to ride out the storm.

Banks want a larger liquid reserves balance as a cushion against higher loan losses. The good news is banks are already loaded up with trillions of dollars in reserves from successive Fed quantitative easing programs (QE1, QE2, QE3) in 2008, 2011, and 2013 (see link for chart):

So banks, while not invulnerable, are already highly liquid. The same can’t be said for all firms and households.

In a sudden economic downturn companies with low cash balances will run out of money very quickly if they can’t access loans. But many companies still have access to credit because in exchange for new loans they have large capital assets to pledge.

Unfortunately most companies are also rushing to borrow lots of rainy day dollars at once and driving up interest rates. For example, ExxonMobil, which is reeling from $25 oil and the Saudi-Russian oil price war, quickly moved to bolster its cash position even as it had already lost its AAA debt rating and was forced to pay an unheard of 60 basis points higher rate than Pepsico on its corporate notes. But in the words of Diamond Hill Capital Management CIO Bill Zox “In an environment like this, it’s all about access to capital, not cost of capital.”

That pretty much sums it up.

So the Fed has moved quickly to make more dollar liquidity available which in turn will also prevent interest rates from skyrocketing.

1) On March 15th the Fed announced it was immediately launching an open market operation to purchase $500 billion in Treasury securities and $200 billion in agency-backed mortgage securities to boost bank reserves. It moved to lower the Fed Funds rate to a 0%-0.25% range, and it dropped the rate it pays on the excess reserves of banks from 1.60% to 0.10%.

Raising bank reserves, lowering the Fed Funds rate, and lowering the rate banks receive on excess reserves are all designed to encourage more lending and raise M1 demand deposit balances.

In the same announcement the Fed lowered the regulatory bank reserve ratio from approximately 10% to zero. To the Economics Correspondent’s knowledge, a zero reserve ratio is unprecedented in the Fed era although pre-Fed suspensions of the gold standard (War of 1812, Civil War Confederacy) could be a rough parallel.

In theory a zero reserve ratio requirement could result in an infinite quantity of demand deposit money created via bank lending, but banks are still disciplined by the threat of customer withdrawals, the Fed can adjust the IOER rate to motivate banks to hold onto a higher level of reserves, and banks are hardly in the mood to lend out 100% of their reserves in the coronavirus economic environment.

Finally the Fed lowered its discount window rate (the rate at which banks can borrow from the Fed directly and which the Fed controls completely) to 0.25% and encouraged banks to use it. In the past banks have been reluctant to approach the discount window during financial crises for fear they will be identified as troubled institutions leading to rapid customer withdrawals (a classic bank run) and failure.

However the current environment is not one of financial crisis, at least not yet, so the Fed has encouraged banks to utilize the discount window without fear of stigma. The Fed’s announcement text is at the following link:

In its March 15th announcement the Fed indicated it would consider other tools to increase liquidity, and it quickly made good on its promise.

2) On March 17th the Fed created an unprecedented Commercial Paper Funding Facility (CPFF) to provide liquidity to lending institutions via purchase of investment grade commercial paper.

3) On March 17th, seeing strains in money markets, the Fed announced the creation of the Money Market Fund Liquidity Facility (MMLF) to purchase high-quality assets from money market funds to provide liquid cash. The MMLF was not entirely novel as a similar facility operated from 2008 to 2010 to support distressed money markets during the financial crisis.

4) On March 20th the Fed announced it would expand the MMLF to make liquid loans to money market funds secured by state and tax-exempt municipal securities. The expansion is not only designed to increase liquidity to the money markets, but also to support borrowing efforts by state and local governments.

5) On March 23rd the Fed announced it was raising its March 15th $700 billion QE program to “unlimited” in a nod to financial institutions that it would do whatever it takes to make liquid dollars available.

And in the widest expansion of its operations into previously untouched credit markets, it also named a wide range of new purchase and lending facilities (too many to name here) that expanded asset purchases to corporate bonds as well as lending operations collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. It even announced it would begin buying corporate bond exchange traded funds (ETFs).

Monetizing corporate assets and lending to institutions using consumer and small business loans as collateral marks a huge step outside the Fed’s traditional asset class boundaries (reminder: before 2008 the Fed only dealt with U.S. Treasury securities).

All these efforts were designed to ensure that in their rush to bolster cash balances to ride out the economic storm, financial institutions, corporations, and to a lesser degree small businesses and households would find no shortage of dollars available provided they meet lending standards

In recent days the Fed has seen money markets stabilize and has reduced its rate of Treasury asset purchases from $75 billion per day, to $60 billion, to $50 billion. It evidently feels its policies are having a moderating effect.

The one group that has always been somewhat left out of the liquidity programs is households. Households with low cash balances are also rushing to boost their reserves but primarily through saving—assuming they still have income. But unlike banks they don’t hold huge quantities of paper assets to sell to the Fed (although if they hold stocks and bonds they can sell them in the open market to raise cash). And households have few large assets they can use to secure large cash loans—typically just a primary home and cars. And cars depreciate and banks are reluctant to lend against them other than for their purchase.

Indeed, on the FOMC’s March 15th conference call Chairman Jay Powell conceded that “About households, it’s true we don’t have the tools to reach individuals… …and people who may be out of work.”

So although the Fed has tried to supply liquidity to banks, money markets, and bond markets to in turn provide cheaper loans to corporations, the process of supporting household liquidity falls more into the domain of unemployment insurance or Congressional stimulus packages.

In Part 3 we’ll discuss the Fed’s less publicized policy response to accommodate the rush for international dollar liquidity.

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.