New Route: The Fed Rides to the Rescue with Unconventional Monetary Policy

In the eight months since the global COVID-19 pandemic hit the United States and its economy, the Federal Reserve has reached far beyond its playbook from the 2007-09 Great Recession, using unconventional monetary policy while growing its balance sheet from roughly $4 trillion to $7 trillion through emergency lending programs and moves to bolster the markets.

This unconventional monetary policy is a form of quantitative easing, in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy while serving to lower interest rates by bidding up fixed-income securities. These actions also expand the central bank’s balance sheet.

The vast emergency response helped stabilize a stock market jolted by the rapidly spreading virus and kept credit flowing in ways that have prevented an even deeper financial crisis.

Fed leaders, including chair Jerome H. Powell, have said a stable turnaround must be in place before the central bank unwinds its interventions. Central bank interventions began in the early days of the pandemic and resulting recession, but much about a recovery is still unknown.

What the Fed Did

As the coronavirus spread in and beyond China last winter and the stock market burrowed further into the red in February, the Fed announced an emergency interest-rate cut of half a percentage point on March 3 (the largest cut, at that point, since the Great Recession). On March 15, twelve days later, the Fed announced it would slash rates to zero and buy at least $700 billion in government and mortgage-related bonds to stabilize the financial system and contend with the mounting crisis.

Both monetary and fiscal policy was used to try to keep the economy from going too far off the rails. (See: https://bowenasset.com/shocks-to-the-system-monetary-and-fiscal-policy/

As Congress hustled to pass the Coronavirus Aid, Relief, and Economic Security (CARES) Act at the end of March, the Fed outlined a sprawling set of programs to flood the markets and boost bond purchases. The agency implemented huge securities-purchase programs, some without limits, going beyond U.S. treasury securities and agencies to buy corporate bonds including those that were below investment grades (which corporate bonds traditionally do not touch).

The Fed also offered credit facilities to many market players, including money market funds and corporations. Importantly, in response to the U.S. dollar funding crisis among non-U.S. banks, the Fed arranged currency swap lines with several major central banks and U.S. Treasury repurchase agreement lines with many other monetary authorities.

As a result, the Fed balance sheet quickly increased from $4.2 trillion in February to a peak of $7.13 trillion in June, an increase of 66%. In the four months since, the growth has been just 1.3%, even though Fed officials have emphasized that they will continue to buy Treasury and mortgage-backed securities at least at the current pace.

In late August, the Fed announced the conclusion of its multiyear framework review. The statement released by the agency began by saying, “The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.”

Then in mid-September, the Fed released new forward guidance on interest rates. The Fed stated its moves would now be on hold until the economy is at maximum employment and “inflation has risen to 2% and is on track to moderately exceed 2% for some time.” In other words, for the Fed to raise rates, the labor market will need to return to “maximum employment” while inflation must increase to 2% and look to be on track to exceed that threshold for an unspecified period.

The major spur driving the Fed to review its published goals was that the agency has been chronically missing its inflation target of 2%. After vanquishing the inflation of the mid-1980s, the Fed successfully managed inflation in the 1990s, 2000s, and 2010s. But fresh challenges emerged: low productivity, low potential growth, goods price deflation, and a flatter Phillips curve (an inverse relationship between the level of unemployment and the rate of inflation). These conspired to push inflation down. For the past decade, inflation averaged only 1.5%. During the longest expansion in U.S. history, with the economy growing at full speed and record job gains pushing the unemployment to the lowest in decades, inflation could not maintain a 2% rate.

There is no magic bullet to solve the Fed’s other problem – that with the Fed funds rate at zero, the Fed’s tool kit is increasingly limited. The Fed acknowledged this challenge in its statement, saying that the Fed funds rate would likely be “constrained by its effective lower bound.” The Fed is quick to point out that it has an unlimited ability to buy a wide variety of assets to stabilize financial markets and therefore support the economy.

The Fed is pledging to leave interest rates low and the balance sheet continues to expand, albeit at a slower pace than the March through May 2020 buildup. The combination of added liquidity and emergency facilities to shore up part of the bond market may well continue to bolster returns across the risk spectrum.

What Will the Fed Do?

The real issue for investors will be what comes after this economic crisis. Many hope that over the coming year or two, the economy will continue its recovery. This could happen even faster should a vaccine or more effective treatments help suppress the pandemic. But the September announcement has made clear that even a return of steady, potential growth would mean the Fed would likely leave rates where they are—at zero. The end of the economic crisis would likely mean the end of liquidity measures, but not the end of the zero-interest rate policy.

Voting members of the Federal Reserve unanimously agreed to keep interest rates near zero for the remainder of 2020 and all of 2021. All voting members, with one dissent, voted to keep interest rates where they are during the entirety of 2022. In essence, the Fed made it crystal clear that it will keep its revised monetary policy.

The stimulus provided by lower interest rates will wear off. Cutting interest rates boosts the economy by bringing future activity into the present; easy money encourages people to buy houses and appliances now rather than later. But when “later” arrives, that activity is missing. The only way to truly keep things going on the monetary side is to lower interest rates further until they hit their lower boundary, which in the U.S. is zero. The Fed does not want to go negative with interest rates or turn to yield curve control. (See: https://bowenasset.com/in-the-feds-tool-kit-what-is-yield-curve-control/

When interest rates stay low for long enough, the policy can become even more counterproductive. In the U.S., monetary stimulus has already pushed bond and stock prices to such high levels that future returns could be lower. If so, people will have to save more to reach their objectives, which means they will have less to spend.

What We Expect

Bowen Asset Management still expects Fed officials to commit to using all their tools. However, monetary policy can provide only limited additional support to the economy.

After the Fed’s regularly scheduled two-day meeting in early November, the agency said that the coronavirus pandemic poses considerable risks for the U.S. economy despite recent gains, and officials made no changes to their commitment to provide sustained stimulus. Powell said they were monitoring two prominent risks to the recent rebound in economic activity: one from rising infection rates and another from households exhausting savings after earlier fiscal relief measures had dissipated.

Consumers and housing were powerful contributors to growth, indicating the significance of fiscal and monetary support measures in securing a rebound. That said, GDP in the third quarter remains about 3.5% below pre-pandemic levels. With fiscal measures such as enhanced jobless benefits concluded and infections soaring, attaining full recovery could be an uphill task. The escalation in new COVID-19 cases will slow the process of economic recovery. Income growth has slowed, and high-frequency indicators such as small-business credit card sales and restaurant reservations have moderated, reflecting a rapidly deteriorating health situation.

The labor market continues to recover. The unemployment rate fell from 7.9% in September to 6.9% in October, a much larger improvement than expected. While the headline numbers were positive, all is not well underneath the surface. The economy has reclaimed 12 million jobs from the trough of the crisis in April, but total employment is still 10 million below pre-pandemic levels. The labor force participation rate increased slightly but remains near its lowest level since the 1970s. We expect the labor market to continue to recover, but only gradually.

One reason Fed officials have been so outspoken about the need for additional government spending is because their stimulus tools are reaching the limits of what they can provide and because those tools are poorly suited to addressing the fallout from the pandemic, economists said.

Even if we get a safe vaccine, distribution will take at least six months to reach the approximately 60% of the population for efficacy—and there remains the question of whether 60% of the population would even agree to get the vaccine.

The Fed’s last meeting of 2020 is December 15 and 16 and its first meeting of 2021 is January 26 and 27. We will know more then.

As always, if you have any questions about this article or any financial questions in general, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.

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