Analysis of Fed Reserve Fiscal Policy in Response to Covid-19
On December 31st, the government of Wuhan, China, confirmed reports that health authorities were treating cases of a new virus that had infected dozens of people in Asia. On January 20th, the United States reported the first case of the Coronavirus in the state of Washington. Despite the incoming chaos, at this point in the outbreak, the U.S. economy was in the best shape that it had ever been. As February arrived, the U.S. reached two critical milestones, the 128th month — and ultimately the last — of the longest economic expansion in U.S. history and the first death from Covid-19 in the United States (Ihrig et al., n.d.). As the pandemic dragged into March, states began to shut down to slow the virus’s spread. This resulted in the closure of all “non-essential” businesses, and the implementation of shelter-at-home strategies for all “non-essential” employees. The halting of the economy has translated into significant consequences for the country at large. One such impact has been the rapid rise in unemployment; after businesses began closing, the unemployment rate jumped to 14.7%, an 80-year-high (Ihrig et al., n.d.). This unemployment jump has also led to a massive decline in GDP as consumer spending decreased 6.6 percent ($1 trillion) in March 2020 and 12.6 percent ($1.8 trillion) in April (U.S. Bureau of Economic Analysis, 1959). In response to these notable disruptions, many firms and individuals sought to liquidate their assets to secure more cash, but because of the speed and volume at which these liquidations occurred, even greater strain was put on the financial market, dropping securities prices drastically. Because of the resulting liquidity freeze, and mass unemployment, the economy was under extreme stress, introducing the need for Federal Reserve intervention. In this paper, I will analyze the methods utilized by the Fed to mitigate economic harm, set the stage for recovery, and gauge their effectiveness. Specifically, I will detail how the Federal Reserve attempted to increase liquidity and spending through decreases to the Federal Funds Rate and how the Federal Reserve used mass purchases of securities to stabilize financial markets.
The first of the Fed’s policies was to decrease the federal funds through the Federal Open Market Committee. As soon as the pandemic’s economic implications were recognized, the FOMC voted to lower the federal funds rate, which serves as the interest rate at which commercial banks borrow and lend their excess reserves to each other overnight.
Decrease in Federal Funds Rate (Federal Reserve Bank of New York, 2000)
The Fed lowered the rate from 1.58% in February to lows of .05% in March, in an attempt to help push the economy forward and increase spending. While the Federal Reserve cannot control the exact federal funds rate, they manipulate it by increasing or decreasing the money supply. In this case, the Fed increased the money supply by purchasing large amounts of U.S securities. These large purchases increased the money supply, driving down the federal funds rate, which in turn drives down interest rates for mortgages, credit cards, and other types of loans. In theory, these lower interest rates should incentivize firms and individuals to take on new loans and spend more to take advantage of these low rates, increasing overall spending and investment in the economy. This increased spending should also improve cash flow and liquidity, which is essential for economic recovery. Doubling down on this strategy, the Fed announced that they would be keeping these sub 1% interest rates for years to come until the FOMC is confident that the economy is making a strong recovery (Fed Pledges to Keep Interest Rates Near Zero for Years — CNN, n.d.).
The Fed’s other strategy has been the purchase of large quantities of private and government securities to ease economic stress and unfreeze markets. This type of expansionary monetary policy is also known as Quantitative Easing; this is a relatively new type of tool used by the Fed to inject cash into an economy. In particular, the Fed focused on buying large amounts of U.S Treasury securities, a vital part of the global financial system, which saw great strain in early March due to volatile prices. This volatility in the markets made it difficult for market activity to occur, further increasing market instability, and leading to a liquidity freeze. In response, the Federal Reserve raised its holdings by more than $2 trillion, with $1.7 trillion being used to purchase U.S Treasury securities. In theory, these large purchases will increase the money supply, making money cheaper, and thus working also to decrease interest rates.
Increase in Securities Held (FRED Graph | St. Louis Fed, n.d.)
Along with decreased interest rates, the addition of these securities to the Fed’s balance sheet would also help keep these assets stable, restoring liquidity to the markets and encouraging more lending and investments. An important point to make is also that by merely holding a large stake in U.S securities, the Federal Reserve signals that they are ready to support the American economy and will take action to backstop essential parts of the financial system.
The Federal Reserve has been widely credited as quick to action and has utilized a wide array of the monetary tools at their disposal in their attempts to stabilize and promote growth in the economy amid a pandemic. While the interest rate was already low, the federal funds rate has been lowered further still to the current range between 0% — 0.25% (Federal Reserve Issues FOMC Statement, n.d.). Despite the success in lowering the interest rate further, the fact that it was already low beforehand makes it challenging to gauge this policy’s effectiveness. Where the Fed has been more measurably successful is in Quantitative Easing. Compared to the 2008 Recession, the Federal Reserve has enacted more aggressive Quantitative Easing strategies far quicker than ever before. The Federal balance sheet has now reached an all-time high of more than $7 Trillion, and top banking officials estimate it could reach as high as $10 trillion (Cox, 2020). Through these actions, the Fed has significantly boosted bank liquidity and overall market stability (Board of Governors of the Federal Reserve System (U.S.) et al., 2020). Despite this, an expansive systemic crisis such as Covid-19 has exposed the limits of the Fed’s tools. A significant issue with the Fed’s approach is that since 2008, the interest rates have been historically low, which leaves the Fed at a disadvantage for implementing monetary policy (First Republic, n.d.). With already low rates, it becomes difficult to stimulate the economy by changing them. Another issue with the Federal reserve’s response is the limitations of its institution. The Federal Reserve is required to “mitigate credit risk by requiring collateral for all loans and by monitoring the financial condition of institutions and other entities that borrow or may borrow from the Federal Reserve” (Federal Reserve Board — Risk Management, n.d.). Because of these limits in who the Fed can lend to, individuals or businesses that may be in the greatest need of these loans would be ineligible. This was particularly evident in the Fed’s Main Street loan program that had a $250,000 minimum and stringent credit requirements, causing it to be criticized widely by economic analysts for being both ill-suited and out of reach for most small businesses (Smith & Politi, 2020).
In conclusion, the Federal Reserve acted quickly and efficiently in implementing expansionary monetary policy to offset the adverse effects of the Covid-19 pandemic. Despite this, its institutional constraints affect the lengths and scope of which it can efficiently stimulate and influence the economy. Ultimately, monetary policy alone will not be enough to ease the complications brought upon by the coronavirus pandemic. It will take a coordinated effort of monetary policy from the Federal Reserve and fiscal policy, such as transfers to households and stimulus supported by Congress.
References
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