US Economic Policies in times of Covid-19

Monetary Policies

During the 1980s inflation was on the rise in the US and reached proportions of stagflation, meaning although economic activity was high, prices were soaring. Double-digit inflation had been reached and that is when the Fed decided to step in. Now it is imperative to understand why inflation was high. The Fed funds rate was very low at the time making it easy for businesses to borrow and lend thus fueling economic activity.The Fed decided to go back and increase the fund’s rate to almost 20% to fight stagflation (contractionary monetary policies), and truth be told it was quite successful in its endeavors. Inflation came back to 3-3.5% but at a huge cost. The sudden increase of the Fed Funds Rate sent shock waves through the economy. Banks started to renege back on deals made and started to cut costs by firing employees left, right, and center. Finances were choked as banks now refused to dole out loans the way they used to. Unemployment hit double-digit figures. This was mainly caused by the subprime mortgage crisis which in turn was the result of the Community Development Act which forced the banks to loosen their credit requirements for lower-income minorities who had no means to pay back what they owed.

During the Great Financial Crisis of 2008, the Fed was the knight in shining armor and helped in mitigating the crisis brought about by unregulated banks and the subprime mortgage crisis. Loans were being sanctioned to customers who had little to no chance of repaying which led to the subprime mortgage crisis. Banks were refusing to take help from the Fed as it would expose their bad debt crisis and their stock prices would stumble like ninepins. As many of these loans were converting into bad debts the Fed came up with the Term Auction Facility to help banks who had a lot of subprime mortgages to stay afloat. This helped the banks maintain anonymity and as a result, no one knew which bank had their books full of subprime mortgages.Banks were afraid to loan money to other banks leading to a severe liquidity crunch. With falling oil prices, inflation was not a concern allowing the Fed to use expansionary policies to infuse liquidity in the market to the tune of around $100 billion.

The Fed slashed the fed funds rate to low or zero to provide the impetus for lending and borrowing thus fueling economic activity. The Federal Funds Rate in the US is the rate at which banks lend money to each other overnight from their excess cash reserves. This is an important arrow in the quiver of the Fed to control financial markets. Slashing these rates makes it easier for other banks to get access to funds. The banks are then expected to extend this benevolence to their customers. But there is a small caveat. The Fed Funds Rate applies to loans that mature overnight and the commercial loans that they make are more long term involving higher risk. Given the volatility of the markets at the time the banks were too afraid to lend out to anyone lest they incur more bad debt.

The two examples cited above are examples of how drastic measures can be taken by the central bank to revive the economy in two very contrasting situations.
(I) When there is too much economic activity going on which results in high inflation: Fed can fight inflation by making it infernal for anyone to get money.
(II) When the financial architecture is failing and economic activity is needed: Fed can make it easier for companies to get access to funds.
The COVID 19 has had disastrous consequences around the Globe and central banks have been fighting tooth and nail to mitigate the effects of this crisis. Let us take a look at some of the measures undertaken by the US.

Quantitative Easing

The Fed has been buying long term securities or bonds to pump in money into financial markets and to encourage buying and lending. The key term to be noted here is “Long Term”. The Fed won’t buy short term bonds as they would expire shortly and would again require payment from the sellers of the bonds. Thus the money infused by the Fed would come back to them without any resounding effects. Excess supply of money would lower the value of money making it easier to lend and borrow and the interest rates drop. The Federal Reserve has announced it has plans to invest close to $700 billion using quantitative easing policies. Now there is a downside to it. Worse, it might lead to inflation without the intended growth leading to a peculiar situation called stagflation. But in the case of US dollars, there will always be demand for it as most of the world’s trade transactions are made using dollars. So this does seem to be a prudent step in times of crisis. In Mid-June the Fed also issued Forward Guidance saying that it will keep buying securities to keep economic activity alive.

Near-Zero Interest Rates

The Federal Reserve has slashed fed funds rate to 0 – 0.5%. The rate applies to loans made by banks to one another that mature overnight itself. This should give more room for banks to figure out their finances.

Desperate times require desperate measures. In times like these, this could not be more true. The Fed has now revived measures that it once used to contain the GFC (Global Financial Crisis): The Primary Dealer Credit Facility (PDCF). Under this facility, the Fed loans out cash to 24 financial institutions for 90 days at a lowly rate of 0.25%. These borrowers are called primary dealers. Primary Dealers, in turn, give investment-grade securities and equities as collateral. The primary goal of this facility is to keep credit markets functioning that are now strapped given that most companies are not looking to invest any more in times of such uncertainty. A similar situation arose in 2008 with banks not looking to lend any more

Money Market Liquid Funds

Now earlier in this article, I mentioned how banks wanted to remain anonymous while borrowing from the Term Auction Facility back in 2008. And they had good reason too. If word broke out that the bank was standing on weak grounds it would send the bank’s customers into a frenzy. They would withdraw cash from their accounts fearing that the bank would collapse leading to more liquidity crisis. A very similar situation has arisen in these times. People have started hoarding cash by withdrawing money from their savings account. While the banks are obliged to honor their requests, they do face a strange problem. The money that they accumulated from the savings of their customers was invested in many different financial instruments and to finance these withdrawals they are required to sell these securities for cash. However, as explained the credit/financial markets are not doing that well and there are not enough buyers too. This has led to the Fed invoking the 2008 crisis-era Money Market Mutual Fund Liquidity Facility (MMFLF) where it would lend money to the banks to finance these withdrawals.

Helping people keep their jobs

Corporate America has now seen massive layoffs across all sectors and unemployment is set to rise even further. The Fed intends to stop this windfall. The Primary Market Corporate Credit Facility (PMCCF) has been launched wherein reputed US companies can borrow from the Fed by issuing new bonds and by introducing deferred payments. The borrowed money gained can be used to pay employees and keep businesses afloat.

Fiscal Policies

Paycheck Protection Program

The legislation includes
(i) US$321 billion for additional forgivable Small Business Administration loans and guarantees to help small businesses that retain workers;
(ii) US$62 billion for the Small Business Administration to provide grants and loans to assist small businesses;
(iii) US$75 billion for hospitals;
(iv) US$25 billion for expanding virus testing.

Cares Act

The Coronavirus Aid, Relief and Economic Securities Act includes tax rebates, expanding unemployment benefits, and helping companies avoid bankruptcy by doling out loans worth $510 billion. The Act passed by President Trump gives $600 in benefits to unemployed people in the US. The act does have some downsides too. Critics argue that the benefits being given are more than what people would earn if they had their jobs thus disincentivizing the need to work.

— Srijan (Co-founder editor)