A decade after the global financial crisis that they helped to combat, Ben Bernanke, Tim Geithner and Henry Paulson published a book in which they warned that new limits on how the Federal Reserve could intervene in financial markets might tie its hands in tackling a future crisis. They surely did not expect their warning to become relevant so soon.
The financial impact of Covid-19, and the draconian shutdown of economic activity governments have imposed to contain it, are more breathtaking even than those of 2008. Two big red lights are now flashing on the dashboard of financial markets. Policymakers, above all the Fed and the US Treasury, must act urgently to prevent market functioning from breaking down.
The first problem is an intensifying squeeze on dollar funding around the world. This is a direct consequence of disruption of the global economy and cross-border supply chains in both manufacturing and services. Production is international, but corporate balance sheets remain overwhelmingly funded in dollars. With goods and services no longer being exchanged, the financial flows to sustain them have dried up too, leaving many scrambling to find the funds to meet dollar-denominated liabilities falling due.
The second is, to an extent, a consequence of the first. Sell-offs, partly to meet the funding squeeze or to unwind complex trading strategies too flimsy to withstand the current shock, have bond markets creaking. The most perverse aspect of the turmoil has been the dumping of assets that in other times would have been in demand as safe havens. The yield on 10-year US Treasury bonds, which reached record lows only last week, has spiked to above its level one month ago. European government bonds, even Germany’s, have sold off, as has gold. We may be witnessing the biggest dash for cash the world has seen. These are serious stresses, which if left unaddressed carry grave risks of further market dislocations or a deeper credit crunch for the non-financial economy.
The Fed has already taken commendable steps. It lowered the cost on existing swap lines that provide other big rich-country central banks with US dollars; these other central banks are now activating dollar-denominated facilities for their local counterparts. The Fed’s infusions of central bank liquidity, and reactivation of several lending facilities from the crisis days, have also helped to oil US markets.
More appears to be needed. The Fed should also offer swap lines to central banks in smaller advanced economies where there are no political complications. For emerging markets experiencing significant dollar funding shortage, it should engage the US Treasury to identify solutions that work politically and are economically effective.
The US Treasuries market, meanwhile, is too important to rely only on private market-making, especially since this shifted post-2008 away from the regulated banking sphere and towards less scrutinised operators such as hedge fund groups; here the Fed must assume the role of market-maker of last resort. It could adopt the “yield curve control” policy the Bank of Japan pioneered. The Fed would target the 10-year Treasury yield directly, committing to buy or sell bonds in sufficient quantity to achieve that rate.
The lesson from the past is that the Fed must be able to intervene quickly and at scale to keep markets functioning. It needs explicit Treasury backing to do this. Fortunately, legal objections do not seem to have prevented it from acting in recent weeks. It should continue to be given all the room for manoeuvre it needs.
