Can a crippling crisis be averted, when the markets are losing faith in the Fed's ability to provide meaningful intervention?
In his disastrous national address yesterday, Donald Trump apparently parroted a line uttered by Citibank CEO Michael Corbat: that "this is not a financial crisis." Banks, they argued, were 'well capitalized' and in a good position to weather the storm.
Then, today, comes news that the Fed is increasing its interventions in short-term funding markets to $1.5 trillion in order to prevent any 'highly unusual disruptions'. This seems a frank admission that we are, in fact, in a financial crisis. I think it is safe to say that when central banks feel it is necessary to offer hundreds of billions or trillions of dollars in short-term assistance across the financial system, that is by definition a financial crisis. Even if, by virtue of that intervention, a longer, more sustained crisis is averted, that does not mean that a crisis point had not been reached, at least temporarily.
Donald Trump, who never learned to read a balance sheet, and whose understanding of how sovereign debt works is so nonexistent that he has actually advocated for negative interest rates because he thinks that they would allow the US to 'refinance' its national debt and save money, is particularly susceptible to magical thinking in regards to economic and financial concepts. He seems to think that Fed target rates are a magic wand that can be waved to counteract any sort of negative economic outcome. Though Trump himself is particularly availed of overly simplistic mental models, this way of thinking seems to have dominated economic and financial thinking in recent years and months, as the Fed always stands ready to pull another rate cut out of its pocket to come to the rescue.
It is worth dwelling for a moment on the role of the Federal Reserve in our financial system. Officially, the Fed is supposed to be a sort of neutral arbiter, not favoring any particular market player or sector, under the dual mandate of maximum employment and stable prices (low-moderate inflation). Therefore the Fed must give the appearance that it is not putting its thumb on the scale for Wall Street, or any other narrow set of interests. Regardless of any 'objective' relationship between interest rates and asset prices, the perception (by Wall Street itself, in particular) is that low interest rates boost asset prices. In economics and finance, the perception is often the reality, and if traders and investors THINK that lower rates will lead to higher prices, their behavior in the market will create that outcome.
Obviously the Fed cannot come out and say that it is juicing stock prices and blowing up a bubble. But it is foolish not to recognize that this has happened in recent years. What is terrifying at this moment, though, is that having built up this giant bubble, the Fed has much less ability to deal with the follow-on effects. The recent rate cuts, and another one that the market has already priced in, are a drop in the bucket compared to what will be required to deal with the effects of the coronavirus-induced economic shutdown. This crisis is only beginning, and will take many months to play out across the world. Once coronavirus goes away, economic activity will not return to 'normal' for many years, if ever (look how long it took to recover from the last financial crisis). We are already almost in a 0% rate environment, and there will be pressure to go to negative rates, even though there is much evidence of the huge dangers of ultra-low or negative rates (including by the Fed's own economists).
There is a growing recognition that the Fed will be powerless in the face of the growing crisis. This FT piece uses the illuminating analogy of drug addiction:
The drugs have now run out, and the withdrawals are going to be horrendous. The realization that central bank intervention was losing relevance had already begun in the lead-up to this crisis. Now that it is sinking in further, markets are terrified. Today's 2300-point drop in the Dow following Trump's abysmally bad speech last night is, in part, a reflection of the realization that this crisis is unlike anything we have experienced, and that in the face of this massive confluence of crises, the federal government is asleep at the wheel, and the Fed is quickly running out of options.
In a rational world, central banks would exist in significant part to avoid these kinds of crisis, and provide meaningful intervention when they happened. Instead, the world's central banks quickly forgot about the last financial crisis, and squandered precious years of valuable preparation time with a misplaced focus on avoiding inflation. Let us hope that the Fed's intervention in short-term lending markets, which is the only meaningful tool that it has left, is enough to avoid a complete meltdown of the financial system, worse than in 2008 or 1929. It is still just too soon to tell, but we will know in the next days and weeks. I'm not very hopeful.
UPDATE: Over the last two weeks, the Fed's response to the coronavirus crisis has taken more shape. Calls for the Fed to go beyond rate cuts and employ and get creative with their response were answered, and quickly. Essentially, the Fed has announced that it will buy any and all assets through a smorgasbord of Special Purpose Vehicles (TALF, CPFF, PDCF, etc.). The term 'QE Infinity' has entered the lexicon, as the Fed assuring markets that it will purchase 'unlimited' amount of US treasuries and MBS (Mortgage-Backed Securities). As Eric Levitz at New York Magazine says, this response is both impressive and alarming. Though this response goes beyond what I imagined when I originally wrote this post, their bazooka/nuclear response proves my original point better than I could have imagined. The fact that the Fed is willing to go to these lengths signals that we are staring into the economic and financial abyss.
We are about to live through perhaps the greatest economic experiment in history, in which we will find out if it is possible to shut down the entire global economy for many months and somehow get it going again when the public health crisis begins to abate. The initial signs, though, are troubling. Already, unintended harmful consequences of the Fed's intervention have begun to show up. By buying massive amounts of MBS, the Fed drove rates back up (which was the goal), but in doing so blew up a common hedge (shorting MBS) used by mortgage bankers, triggering a wave of margin calls which is threatening to derail the industry.
This crisis goes beyond anything that governments and central banks have had to deal with, at least in our lifetimes, and maybe ever. It is hard to overstate how much of a departure the response of the Federal Reserve is from past crises, and how unprecedented these new measures are. The calculation is that we might be able, as a nation and a global society, to get through this crisis if we do not also deal with a major financial meltdown. But it already looks like that is creating a situation in which financial markets are relatively sound (compared to where they could be), while the larger economic fundamentals (incomes, employment) are completely disastrous.
While billions of dollars have been quickly made available to rescue financial markets, assistance for main street and the real economic is going to be much slower to arrive. Unemployment programs are overwhelmed, and the new SBA loan program is already off to a rocky start. It is looking more and more like relief will take weeks and months for many of us, and many people and businesses will slip through the cracks. In a few weeks or a few months, many businesses will have already failed. Trillions of dollars of support to financial markets might not do much to help the larger crisis if tens of millions of people are out of work with no prospect of income any time soon. We simply have never been here before, and only time will tell if the global economy can survive this massive set of shocks.