Summary:
• The coronavirus crisis differs from the 2008 crisis in part due to the high level of uncertainty it has generated, particularly in the United States.
• This difference between the uncertainty observed in 2008 and 2020 is due in particular to (i) the exogenous nature of the COVID-19 health shock, as opposed to the endogenous shock caused by the subprime crisis, and (ii) the combination of negative supply and demand shocks, which have opposite effects on macroeconomic fluctuations.
• In response to this unprecedented shock, the Federal Reserve immediately lowered its key interest rate to its floor level, before launching massive asset purchase programs and aid packages for households and businesses.
• Despite a lack of visibility on inflation forecasts, the Fed seems more than ever to be taking uncertainty into account in its decisions. The decision on August 27, 2020, to define a new monetary policy framework that tolerates an inflation target above 2% shows the willingness of the US monetary authorities to have greater room for maneuver if this type of shock were to recur.
Usefulness of the article: this article attempts to explain how the Federal Reserve responded to the coronavirus shock in the United States. First, it reviews the timeline of the Fed’s main actions since the start of the pandemic in the United States. It then attempts to explain why these decisions were difficult but crucial in a period marked by a particularly high level of uncertainty.
The coronavirus epidemic represents a major challenge for populations and policymakers in the countries affected. On April 11, 2020, the United States became the country most affected by the now pandemic, with nearly 527,000 cases of infection and more than 20,500 deaths linked to the virus at that time. In order to prevent, or at least slow down, the spread of the coronavirus, the US authorities opted to lock down the population. Although necessary from a health perspective, this decision nevertheless constituted an unprecedented economic shock for the US economy, prompting the Federal Reserve (Fed) to implement a series of measures to cushion this considerable shock.
This note follows on from Julien Pinter’s article of July 6, 2020, on « The European Central Bank’s response to the coronavirus, » and is the second part of the BSI Economics series on the response of central banks to the COVID-19 crisis. Here we focus on the Fed’s actions in the United States since the start of the pandemic. How has the US central bank responded to the coronavirus crisis?
Chronology of actions
First, let’s start by putting the Fed’s successive decisions to deal with the COVID-19 crisis into perspective, before attempting to explain why these measures are appropriate given the situation. These decisions refer to the main announcements made at press conferences (in bold) or in press releases in the months following the lockdown measures:
– On March 3, the Federal Open Market Committee (FOMC), the Fed’s monetary policy committee, decided to lower the US key interest rate by 50 basis points to between 1% and 1.25%.
– On March 15, the FOMC met again and announced: (i) a 1 percentage point cut in its key interest rate (from 1-1.25% to 0-0.25%), (ii) coordinated action by central banks to ensure the creation of new dollar swap lines, (iii) a program to purchase $500 billion of U.S. Treasury bonds and $200 billion of mortgage-backed securities (MBS), MBS), which is essential to supporting credit to households and businesses.
– On March 17, the Fed announced the implementation of two emergency plans: the Primary Dealer Credit Facility (PDCF) and the Commercial Paper Funding Facility (CPFF), both of which consist of supporting and guaranteeing the credit needs and flows of households and businesses.
– On March 18, the Fed announced an extension of its emergency plan by launching the Money Market Mutual Fund Liquidity Facility (MMLF), dedicated to preserving money market mutual funds to ensure liquidity in the event of investor withdrawals.
– On March 19, the Federal Reserve established new dollar swap lines available to other central banks.
– On March 23, in a press release, the Fed announced its intention to take stronger action to support credit to the private sector, in particular by announcing the purchase of an unlimited amount of U.S. Treasury securities, MBS, and corporate bonds. The latter is seen as an important innovation compared to the 2008 crisis.
– On March 31, the Fed announced the establishment of a temporary program, the repurchase agreement facility for foreign and international monetary authorities (FIMA Repo Facility), consisting of authorizing foreign monetary authorities to exchange US Treasury bills for dollars on a short-term basis. The Fed once again demonstrated its responsiveness in order to avoid any global dollar liquidity crises.
– On April 9, the Fed announced $2.3 trillion in new loans, intended in particular for struggling businesses and local authorities. Among the new programs announced are the Paycheck Protection Program Liquidity Facility (PPPLF), which will lend to financial institutions helping SMEs whose loans are themselves guaranteed by the Treasury, the Main Street Lending Program, which is a system of loans to SMEs, the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) for the purchase of corporate bonds on the primary and secondary markets, the Term Asset-Backed Securities Loan Facility (TALF) for the purchase of tranches of securitized products rated as risk-free, and the Municipal Liquidity Facility (MLF), which consists of the purchase of short-term securities issued by local authorities.
– On April 29, the Fed kept its key interest rate between 0 and 0.25%. The FOMC announced that it was prepared to use « the full range of tools » at its disposal to mitigate the effects of COVID-19 on the US economy.
– On June 10, the Fed kept its key interest rate between 0 and 0.25%. Despite the rebound in the US economy expected in 2021, the FOMC suggested that rates would remain unchanged for as long as necessary to achieve its goals of price stability and full employment.
– On June 15, the Fed announced its intention to extend its Main Street Lending Program to non-profit organizations and announced an update to the Secondary Market Corporate Credit Facilities.
– On July 17, the Fed modified its Main Street Lending Program, which now includes schools, hospitals, and social service agencies.
– On July 23, the Fed announced improvements to the Term Asset-Backed Securities Loan Facility, Secondary Market Corporate Credit Facility, and Commercial Paper Funding Facility by adding new counterparties.
– On July 29, the FOMC meets and discusses a new monetary policy framework, mainly concerning the communication of long-term objectives and the Fed’s strategy. FOMC members are particularly concerned about the uncertainty surrounding the economic recovery in the United States.
– On August 27, the FOMC announced a new monetary policy framework, according to which the Fed could temporarily tolerate inflation above 2%.
– On September 16, the Fed announced its intention to maintain its zero interest rate policy at least until the end of 2023.
Overall, the non-exhaustive list above shows that the Fed has responded vigorously to the economic shock caused by the coronavirus health crisis. The successive cuts in key interest rates on March 3 and 15, followed by credit facilities for households and businesses and securities repurchase programs, appear to be the necessary tools to respond to the COVID-19 crisis. Furthermore, the gradual extensions and improvements to these new programs seem to highlight the ambiguity of the situation, linked to the uncertain nature of the coronavirus’s impact on the US economy.
What can we learn from the Fed’s response to the pandemic?
Given the situation and the equally exceptional monetary policy measures in the United States, it seems important to examine the Fed’s response to the shock that has affected the US and global economies. To do so, a comparison with the 2008 crisis seems necessary in order to understand the challenges of responding to the current crisis, before attempting to provide important insights into the uncertain nature of the shock caused by the COVID-19 crisis.
How does it differ from the 2008 crisis?
Following the spread of the coronavirus pandemic and the measures taken in response, the question of the severity of the « Great Lockdown » (as the International Monetary Fund has called the current recession) compared to that of the « Great Recession » following the 2008 crisis quickly arose in the debate.
In the CEPII Blog of March 26, 2020, Aymeric Ortmans and Fabien Tripier present a dashboard for tracking the main indicators of uncertainty in the United States and comparing their evolution with that observed during the financial crises of 1987 and 2008 (Graph 1).
It shows that the fall in the US stock market in 2020 was comparable in proportion to that of 2008, but that indicators of financial uncertainty (stock market volatility, corporate bond spreads) and economic policy uncertainty increased more significantly and persistently in 2020 than at the time of the Lehman Brothers bankruptcy in 2008.
Figure 1: Evolution of uncertainty in the United States
Sources: Ortmans and Tripier (2020)
The relatively long period that has elapsed since the start of the pandemic also allows us to analyze macroeconomic data at a lower frequency than the financial data studied above. Chart 2 shows the evolution of real GDP growth and the unemployment rate in the United States since 2007.
Figure 2: Changes in real GDP growth and the unemployment rate in the United States
Sources: FRED
The trends in real GDP and the unemployment rate show a sharper and more pronounced decline in activity in 2020 than in 2009. As a result, the unemployment rate rose gradually from 5% to 10% during the Great Recession, while it literally exploded from 3.5% (its lowest level in nearly 50 years) to nearly 15% during the current crisis.
As highlighted above, and as Marc-Olivier Strauss-Kahn, Honorary Director General of the Banque de France, points out, the causes, process, and duration of the recession mark a notable difference between the events of 2008 and 2020. Another difference lies in the policies put in place to respond to it, particularly the reaction of the monetary authorities.
Uncertainty: a major challenge for monetary policy during the health crisis
Faced with particularly high uncertainty and the sharp and sudden deterioration in macroeconomic indicators observed during the current crisis, the Fed’s response was strong and immediate. Chart 3 highlights the scope of the decisions outlined above: the cut in the key interest rate to the floor level and the securities purchase and private sector assistance programs (seen as a major step forward in Fed policy compared to 2008).
Chart 3: Fed funds rate and size of the Federal Reserve’s balance sheet
Sources: FRED
Let us now turn to the monetary policy implications of the unprecedented shock of uncertainty that characterized the 2020 crisis. We will focus in particular on one of the Fed’s main missions: price stability.
First, the exogenous nature of the 2020 shock (as opposed to the endogenous nature of the 2008 shock) made macroeconomic forecasts particularly difficult. At the same time, macroeconomic uncertainty was fueled by the combination of a negative supply and demand shock, with diametrically opposed effects on prices.
The negative supply shock stemmed primarily from the nationwide shutdown of certain activities and the halt in supplies to certain companies, particularly given China’s position in global value chains. It was then amplified by lockdown measures, which contributed to a negative productivity shock attributable to the implementation of health measures in companies. The negative supply shock will therefore tend to increase production costs and, consequently, prices.
The negative demand shock, on the other hand, will tend to lower prices: it is linked in particular to the decline in private consumption and investment during lockdown.
In summary, the exogenous nature of the shock and the combination of supply shock and demand shock suggest that global uncertainty could be reflected in inflation forecasts. Chart 4 confirms this intuition. The increase in inflation uncertainty when the pandemic hit the United States is a real headache for the FOMC: the appropriate monetary policy must therefore be conducted taking into account this particularly high level of uncertainty.
Chart 4: Inflation uncertainty in the United States
Sources: Federal Reserve Bank of New York
Conclusion
The health, financial, and macroeconomic shock caused by the coronavirus has put the Federal Reserve, like other central banks, under severe strain. In response to the uncertainty generated by this exogenous shock, the Fed has been both responsive and innovative in the face of an unprecedented situation. Paradoxically, despite all the differences between the two crises, the Fed seems to have learned the lessons of the 2008 crisis.
The Fed’s last two announcements, on August 27 and September 16, show not only the persistence of the coronavirus crisis, but also the institution’s willingness to act immediately in the face of this type of shock. By declaring its intention to temporarily target inflation above 2% and committing to maintaining a zero interest rate policy at least until the end of 2023, the Fed is clearly signaling its desire to anchor long-term expectations in order to reduce the uncertainty inherent in the current crisis.
