The US Federal Reserve has taken a number of aggressive steps to help financial markets keep moving and aid banks to deal sympathetically with borrowers, in a move reminiscent of its response to the financial crisis more than a decade ago.
Sunday night’s surprise 1 percentage point rate cut took the Fed’s main policy rate back to where it last was in 2015 but in announcing the measures Fed chair Jay Powell made clear that it was the flurry of other more technical changes that were the biggest news.
Last week the European Central Bank and the Bank of England took steps to increase commercial banks’ ability to help tide companies and households over financially during the economic crisis created by coronavirus. The Fed’s actions followed the same path.
Liquidity, Mr Powell said, “is right now the most important thing that we’re doing”. By contrast, interest rates will “matter a lot more when the economy begins to recover”.
Rick Rieder, BlackRock’s chief investment officer of global fixed income, said: “During times of crisis like 2008, it is innovative and new strategies appropriate to the environment that are important, and they just did it. I give them tons of credit.”
Mr Powell acknowledged that central banks cannot solve a pandemic; but what they are good at, he said, was providing money and support to financial systems “when they’re under stress” to ensure they do not amplify the problem.
Here are three ways the Fed did that — and one measure it held off on.
Ensuring markets function normally
In the past week the vital markets that underpin the financial system have begun to show signs of strain, so the first part of the Fed’s action was to purchase sufficient assets to ensure prices reflect underlying reality and people can buy and sell normally.
Specifically, the markets for US government debt, or Treasuries, and for agency mortgage-backed securities — bundles of mortgages guaranteed by Fannie Mae and Freddie Mac — have both begun to behave abnormally. So the Fed announced it would buy at least $500bn of Treasuries and at least $200bn of agency mortgage-backed securities.
Michael Feroli, chief US economist at JPMorgan, said this measure resembled the first round of quantitative easing during the financial crisis, when the Fed bought mortgage-backed securities because investors were too scared to even come up with a price.
Changing bank rules
Businesses and consumers are about to experience a cash flow crunch as economic activity slows down sharply. In an acknowledgment that banks can help tide them over, the Fed eased restrictions on the US banking system.
Since the financial crisis the largest US banks alone have built up $2.9tn in high-quality liquid assets, according to the Fed announcement. The Fed told these banks they could use those buffers to make more loans to businesses and consumers. The remaining smaller banks tend to keep fewer excess reserves at the Fed as a buffer; to help them the Fed eliminated reserve requirements for all banks.
The Fed also lowered the rate it charges banks at its discount window for short-term loans, extended the length of the loans to as long as 90 days, and encouraged banks to use the window. In the past accessing this facility has carried a stigma; now the Fed wants to make sure banks are comfortable if their customers all suddenly draw down lines of credit.
This help still leaves banks with a problem: now the Fed’s policy rate is at zero, it has become harder to attract deposits at a rate substantially below their returns on lending.
Gerard Cassidy, an analyst at RBC, said the Fed’s discount lending was more important than the rate cut. “To get through this economic shock the Fed has to provide liquidity to the [banking] system to prevent the bank earnings downturn turning into a balance sheet problem,” he said.
Helping other central banks
The Fed did not just act unilaterally on Sunday — it also announced co-ordinated action with the central banks of Japan, Europe, the UK, Canada and Switzerland to lower the cost of borrowing dollars internationally.
These central banks have standing swap lines with the Fed, meaning they can access dollars in exchange for their own currency, ensuring that their banks — which cannot access the Fed but have a need for US dollars — will not run short.
On Sunday the Fed lowered the cost of borrowing dollars through these swap lines and created a new, longer-term liquidity facility.
According to Jon Hill, a rates strategist at BMO Capital Markets, the move suggested the central bank feared the makings of a much larger issue.
“Given the scale and speed they are moving, they are concerned this is going to turn into a true funding crisis globally,” he said.
What the Fed did not do
One of the major pain points in markets which the Fed did not directly address is the commercial paper market, where companies borrow money for short periods rather than having an overdraft at a bank.
Money market funds — big buyers of commercial paper — began to sell because they expected their investors to pull money out, just as the shock of coronavirus has increased companies’ funding needs. According to analysts at Bank of America the commercial paper market is “frozen”.
Mark Cabana, an interest rate strategist at Bank of America, said he was “surprised” the Fed did not announce direct measures to mitigate the problem. “This is a key source of funding for corporations and it is an important liquidity outlet for money market mutual funds,” he said.
Under the Federal Reserve Act, the Fed would need consent from the Treasury department to buy financial assets it does not usually purchase, such as commercial paper. Mr Powell said this kind of co-operation with the Treasury was “part of the playbook”, but he had nothing specific to announce.
This article has been amended after publication to clarify the scale of banks’ high-quality liquid assets.
