Today the Federal Reserve made a series of surprise announcements to support the credit needs of households and businesses. The Federal Reserve announced measures related to:
- The Fed Funds Rate
- The Discount Window
- Intraday Credit
- Bank Capital and Liquidity Buffers
- Reserve Requirements
- U.S. Dollar Liquidity Swaps
This follows on the heals of a policy statement from March 9th setting the stage for banking policies to accommodate the shocks to the global economy caused by a pandemic. It's not unprecedented for the central bank to surprise the financial markets. It's very uncommon to happen on a weekend, indicating something very serious afoot. However, the response appropriately addresses the broad realities and long term understanding of this present situation.
As pointed out in the surprise
FOMC statement, before SARS-Cov-2 swept the globe, the U.S. economy macro-statistics were very strong. Consumers did what consumers do: consume. Employers did what employers do: employ. Banks did what banks do: lend and spend. There were no fundamental flaws in general, daily, normal economic activity.
However, uncertainty breads fear, and fear breads panic, and panic breads unpredictable and irrational human behavior. That's not to say everyone's decisions are bad. It says a flood of unexpected data (money) hits institutions' computer management models without warning. The systems that manage and keep banking and economic activity flowing smoothly contain alerts and notifications. Those systems primarily help bank regulators identify weak banks in need of behavioral change to avoid default and bankruptcy. When panic ensues, those indicators become untrustworthy.
The lessons from the Great Depression informed central bankers that banks must operate by different standards than normal human beings. Individuals grab all their stuff and anything they can get their hands on to make sure they aren't left holding an empty bag. That's how bankers in 1931 behaved as well - demanding everything that was rightfully theirs (the "money owed them" by mortgage debtors). Just when common folk need a little grace and understanding, the banks laid down the law!
Today central banks operate as the steady hand of reason behind the financial systems that otherwise swing out of control by the financial decisions of an out-of-control swarm of human actors all demanding what is rightfully theirs. If we could call a time out, put life on hold everywhere, and wait for the virus to dissipate, we could all make rational adjustments for whatever the new normal becomes.
Today's series of policy changes achieves the same thing - buying time for everyone to discover the new normal. Let's see how that works.
Joint Agency Press Release
On March 9th, six bank regulatory agencies together published a response to the stress unleashed by the coronavirus on financial institutions.
Federal financial institution regulators and state regulators today encouraged financial institutions to meet the financial needs of customers and members affected by the coronavirus. The agencies recognize the potential impact of the coronavirus on the customers, members, and operations of many financial institutions and will provide appropriate regulatory assistance to affected institutions subject to their supervision.
The regulators also will work with affected financial institutions in scheduling examinations or inspections to minimize disruption and burden.
Bank regulators have authority to demand certain actions by bank managers when financial institutions assets become threatened. Essentially this press release tells those regulators to stay calm and take it easy on the banks. It acknowledges the inevitable difficulty of bank customers as the virus spreads through our communities, putting the regulators on notice that the governing agencies expect them to be team players for everyone's welfare. This buys time by allowing banks to extend grace periods and additional credit to customers that have always been reliable and stable, not holding them responsible for matters outside their control.
March 15th Series of Actions
Federal Reserve FOMC statement
In a
surprise move to drop the federal funds rate (Fed Funds) to virtually zero, the federal reserve (The Fed) points out correctly the fundamental strength of the economy before the virus started making headlines: "
Available economic data show that the U.S. economy came into this challenging period on a strong footing." They also point out, "
The coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States." In response The Fed plans to increase U.S Treasury holdings by $500 billion and $200 billion of mortgage backed securities (MBS) over the next few months.
Lowering the fed funds rate lowers the cost of working through this period for business and households. Think of the fed funds rate like the wholesale price of credit. Buying MBS pulls mortgages off the books of banks, motivating them to extend additional mortgage credit to households. This ensure those who need to move can repurchases homes elsewhere, and makes funds available to those who need to pull equity out of their homes to get through the cash shortages caused by temporarily closed small businesses.
Purchasing Treasurys is most intriguing. The combination of increased federal spending and reduced tax flows creates rapidly expanding deficits. A weakened economy won't have capacity to absorb that debt, which would otherwise increase interest rates from the flood of new securities (higher supply producing lower prices, and
bond interest rises as bond prices drop). These purchases also buy time, because moving Treasury debt to the balance sheet of the central bank removes it from the economy at large. The combination of federal payments to cover coronavirus expense while simultaneously moving the Treasury debt out of the economy eliminates the dilutive effect of excess spending, keeps pressure off of inflation when the economy needs all the help it can get, and
eliminates the cost of new debt on the Treasury.
Actions to Support the Flow of Credit
Four specific banking tools were simultaneously adjusted to essentially grease the skids and simplify credit flows without banks violating traditional constraints imposed under normal market conditions.
The Fed adjusted the discount rate, encouraged the use of intraday credit, acknowledge the appropriate use of capital and liquidity buffers to support prudent solutions to the present economic strains, and lowered reserve requirements to free up additional credit.
Since the global financial crisis of 2007-2008, U.S. bank holding companies have built up substantial levels of capital and liquidity in excess of regulatory minimums and buffers. The largest firms have $1.3 trillion in common equity and hold $2.9 trillion in high quality liquid assets. The U.S. banking agencies have also significantly increased capital and liquidity requirements, including improving the quality of regulatory capital, raising minimum capital requirements, establishing capital and liquidity buffers, and implementing annual capital stress tests.
It's important to understand all that money and those assets, by regulation, are unavailable to banks for lending. It would be foolish, though, for those reserves designed for this time of economic stress to be the very instrument that exacerbates economic stress because of regulatory restrictions binding the banks and preventing them from the necessary response to keep businesses and households from collapse.
Without delineating the regulatory framework of these tools, suffice to say this combination ensures banks and regulators both understand the changes in bank policy since 2008 were specifically established for times like this. Therefore, it's appropriate in the view of the central bank and agency regulators to use the resources accumulated over the years to provide banking services to businesses and households in a prudent manner for the welfare of all. Just like a stockpile of grain "reserves" accumulated in the fat years feeds the masses in years of famine, those "reserves" in the banking system were designed to feed the lending requirements in lean economies.
U.S. Dollar Liquidity Swaps
U.S. Dollar
Liquidity Swaps represent central banks lending to central banks. In our global economy, banks around the world convert foreign currencies between each other. Currency is a sovereign asset. When a European business needs dollars, or an American business needs Euros to settle transactions across borders, someone with extra dollars or euros must be found to provide the currency. Under market stress, finding and moving those currencies can be hampered by institutions dealing with other issues, market or regulatory requirements making the currencies unavailable for lending, or higher demand for a foreign currency than normal in one sovereign jurisdiction.
This announcement simply indicates the central banks of Canada, England, Japan, Switzerland, the European Union, and the United States all agree to lower the cost of liquidity swaps, and also provide 84-day arrangements in addition to the existing 1-week arrangements. Everyone knows this crisis is not going to resolve itself in a few weeks. Offering 84-day terms improves efficiency of liquidity swaps by allowing counter parties to focus resolving internal affairs rather than returning weekly to process and monitor swap agreements and currency requirements. In short, buying time for international currency demands to normalize while stress conditions unfold and eventually unwind.
