The US Federal Reserve’s (Fed) Pandemic Monetary Policy, Lessons to Central Banks

The Fed’s latest decision (July 28, 2021) was to keep its present monetary policy stance unchanged.

      The Fed in its media release (July 28,2021) stated that “The path of the economy continues to depend on the course of the virus. Progress on vaccinations will likely continue to reduce the effects of the public health crisis on the economy, but risks to the economic outlook remain.” “The Fed is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.”

Accordingly, the Fed’s decision was to continue with the present level of ultra-lose monetary accommodation with tools as highlighted below.

• Overnight federal funds rate target of 0%-0.25%, primary credit rate (discount rate) at 0.25% and interest paid on reserve balances (overnight bank deposits at the Fed) at 0.15%
• Monthly purchase of assets at US$ 120 bn, i.e., US$ 80 bn of Treasury Securities and US$ 40 bn of Agency mortgage-backed securities (MBS) and increase amounts further and purchase of agency commercial mortgage-backed securities (CMBS) if needed to sustain smooth functioning of market of those securities.
• Conduct overnight rep operations with a minimum bid rate of 0.25% and with an aggregate limit of US$ 500 bn. whereas the aggregate limit can be temporarily increased at the discretion of the Fed Chair.
• Conduct overnight reverse repo operations at an offering rate of 0.05% and with a per-counterparty limit of US$ 80 bn. per day. The per-counterparty limit can be temporarily increased at the discretion of the Fed Chair.
• Rollover at auctions all principal payments from the Fed’s holding of Treasury securities and reinvest all principal payments from the Fed’s holdings of agency debt and agency MBS.

Present Policy Background

As the immediate response to the global corona pandemic, the Fed was the first central bank to activate the most significant package of monetary accommodation as highlighted below. The package was intended to ease financial conditions to historic levels in order to avert the occurrence of any liquidity crunch in the economy in response to the pandemic-related uncertainties and to keep financial markets active and stable.

• 03 March 2020 (Emergency meeting) - Cut the federal funds rate target by 50 bps to 1%-1.25% range.
• 12 March 2020 (Emergency meeting) - Announced to inject nearly US$ 1.5 tn new liquidity and offered US$ 500 bn in a three-month repo operation.
• 13 March 2020 – conducted US$ 1,500 bn term repo auctions
• 15 March
• Cut the federal funds rate target by further 100 bps to 0-0.25% 
• Cut the primary credit rate by 150 bps to 0.25%
• Reduced reserve requirement ratios to 0% (from 10% and 3%)
• Increase holdings of Treasury securities by at least $500 bn (a wide range of Treasuries inclusive of 30Y) and MBS by at least US$ 200 bn
• Introduced a US Dollar swap facility with several central banks with an 84-day maturity
• 31 March 2021 – Repo credit facility to central banks and international monetary authorities to borrow from the Fed against their holdings of US Treasuries
• 9 April 2020 - Announced funding schemes to provide US$ 2.3 tn in loans to support U.S. households, businesses, and communities
• During March – April 2020, the Fed introduced 11 funding schemes to support targeted sectors of the economy and eased bank credit regulations to promote credit delivery across the economy. Some of the credit schemes were implemented with the Treasury’s funding support under the CARES Act passed by Congress on 27 March 2020 to authorize fiscal measures in respect of the pandemic.

Decision Background

• Present inflation in June – 5.4% (as against the average inflation target over time of 2%)
• Unemployment rate in June – 5.9%
• Money printing since end of 2019 - The Fed’s balance sheet increased to US$ 8,221 bn as of 28 July 2021 indicating a 97% increase in money printing
• Growth of money supply from February 2020 to June 2021 – 32.6%
• Growth of monetary base from February 2020 to June 2021 – 74.5%
• Ample liquidity in the banking sector – Between February 2020 and June 2021, bank reserves at the Fed has increased by 132% with currency in circulation increased by 21.2%

Learning Outcome

• The Fed innovatively and aggressively operated the monetary policy and bank regulations to fight the pandemic-hit-economy. It went out of the conventional short-term inter-bank interest rate and liquidity target policy model to a diversified credit delivery model to support the businesses and households for the recovery from the pandemic impact.
• Immediately after announcement of ultra-lose monetary accommodation in early March 2021, Chamath Palihapitiya (a billionaire in his 40s) of Sri Lanka origin who is a Californian-based investor (Social Capital) on the Wall Street commented that the Fed’s lending has no use at this time of lockdown and social disruptions due to pandemic and that the state should distribute money freely to households. Then, the US government got activated for fiscal grants to households and businesses.
• With huge injection of liquidity through the purchase of Treasury securities and others by the Fed and historic interest rate cut, Treasury yields of all maturities fell below 1% first time in history. The benchmark 10-year yield which was around 1.80% at the beginning of 2020 fell to 0.45% at the mid-year. With the positive economic sentiments and rise in inflation expectations, it started rising from around 0.90% at the beginning of 2021 to 1.73% in the 3^rd week of March, but surprisingly started falling and hitting 1.23% at the beginning of August 2021. This is due to speculative trades between treasuries and private securities.
• The monetary policy has immensely facilitated the fiscal stimulus package of nearly US$ 5 tn so far at interest rates close to zero with ample liquidity supplied to Treasuries and credit markets through term auctions and yield controls. Nearly 52% of the Fed’s balance sheet is long-term government bonds. The Fed Chair Jeromy Powell commented that the Fed has only lending powers which are not sufficient to address this humanitarian crisis and invited the government to use its lending and taxing powers to provide stimulus to households and businesses. He accepted the resulting debt overhang but commented that the debt problem and inflation possible from fiscal stimulus could be resolved later. He further expressed that the Fed is not concerned over the hypothesis of possible inflation and, instead, intends to use its full range of tools to support its economic goals.
• This monetary policy has helped immensely to restore the aggregate demand in the economy, despite the continued pandemic risks. Janet Yellen, the former Fed Chair and the new US Treasury Secretary stated that ” low interest rates are likely to be long term and the smartest thing is to act big on stimulus at historic low interest rates for the recovery of all segments of the US economy.” The latest estimate for the US fiscal deficit in the fiscal year 2021 is US$ 3 tn, 10.2% of GDP, due to such fiscal stimulus package.
• Although markets and economists did not comment on ultra-lose monetary policy and fiscal stimulus at the beginning, they now appear to raise serious concerns over significant inflationary pressures in the future and to comment on the need for commencing to taper the Fed’s asset purchases soon and tighten the monetary policy to prevent inflationary pressures from getting out of hand. Some talk about consequences of a possible overheating of the US economy.
• The Fed’s response is that the inflationary pressures are transitory due to disruptions of supply chains consequent to the pandemic and are expected to disappear when the economy recovers gradually over time whereas it has tools to address such pressures if they become permanent.
• The inequality in the US has risen to historic high levels in all segments of people as the direct impact of the pandemic. The Fed Chair accepts the responsibility of the monetary policy to address unfair inequality by streamlining the credit delivery.
• The Fed does not express any views on any timeline of tightening the monetary policy. It took more than a decade in respect of the global financial crisis 2007/09 and experienced a serious fault by starting to tighten the monetary policy in 2018/2019. The Fed Chair expressed that the Fed was not willing to do the same mistake at this time. However, markets are betting and gambling on possible tightening timelines as they speculate.
• Above is only the shortest version of the Fed’s pandemic monetary policy story. It shows how money and credit can rescue the public from the pandemic, despite usual concerns raised by some schools of economists over debt and inflation. Many developing countries struggle in the pandemic since their policymakers prioritized the control of debt and inflation (conventional fiscal space and unknown inflation-based monetary policy model) over the recovery of the public from the pandemic. The passion of the Fed Chair being a non-economist in talking to the media in plain language leaving aside the monetary policy jargon and hypotheses is also exemplary. The Fed has helped the world by supplying dollars abundantly to facilitate the recovery of global supply chains disrupted by the pandemic.
• All central banks have followed the wind of policy relaxations activated by the Fed, but they miss the timeliness, the intensity and the volume. Central banks in the developed world are close to the Fed’s policy model. However, central banks of developing countries are far away from this vigor. Therefore, most developing economies are now in the disarray of the management of both the pandemic and the economy due to their own domestic thinking and myths.