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Repeat After Me: “The Central Bank is the Lender of Last Resort”

On Sunday, March 15, the Federal Reserve announced sweeping measures aimed at improving market liquidity and combating the looming economic slowdown. These measures include:

  • Lowered the federal funds rate by 1% to a target range of 0% to 0.25%
  • Lowered the discount rate (bank borrowing at the Fed) by 1.5% to 0.25%, extended loan duration, and encouraged discount window borrowing
  • Eliminated banks’ reserve requirements, thus freeing up a large amount of bank capital
  • Along with six other global central banks, lowered U.S. dollar swap rates by 0.25% and extended swap duration to improve global liquidity
  • Implemented a new Quantitative Easing (“QE”) program to buy up to $500 billion of Treasury securities and $200 billion of mortgage backed securities in the coming months

These are important and meaningful steps to help offset the looming economic slowdown. Unlike the financial crisis in 2008/2009, however, the root issue is not financial in nature so financial easing alone is not a panacea.  Chairman Powell, when asked about the role of fiscal measures to address the economic slowdown, did not mince words – “Fiscal response is critical.”

Following the announcement, futures markets and international equity markets retreated. The primary reason for this market reaction is likely the accelerating economic slowdown that is becoming more evident by the hour as closure announcements and business activity restrictions take hold. A secondary reason, however, may be a recognition that interest rates falling to zero are of little benefit at the moment when business activity is contracting at an alarming pace. This point is true enough in the immediate term, but Congress is now putting together a fiscal stimulus package. Hopefully lawmakers, too, are reassessing the level of assistance that is necessary to prevent lasting damage to the economy. It is crucial for legislatures to meet the moment.

Amid the bleak U.S. headlines, we should not overlook examples that point to guarded optimism. South Korea, once an alarming outbreak zone, now appears to have the coronavirus outbreak relatively under control. Social distancing, school shutdowns, and mass testing resulted in new cases going from 586 on March 1st to a mere 76 on March 15th. Italy and other European countries remain firmly in the throes of the outbreak, however, and different regions have seen vastly different outcomes to date. 

Coming full-circle back to the Fed: We believe it would be misguided for the markets look at today’s significant monetary policy developments and conclude that “the emperor has no clothes.” Section 13(3) of the Federal Reserve Act allows the Fed to provide loans to both financial and non-financial companies in extraordinary circumstances and within certain guidelines. We presume that the Fed is working vigorously to develop a plan that would help float business through this difficult period if necessary. Indeed, the coronavirus outbreak is an external shock that, while all-consuming in the moment, is nonetheless temporary in nature. After 9/11, such loans were also contemplated for the airline sector, but the scope now is obviously larger in terms of economic impact.

The last question during Chairman Powell’s press conference asked specifically about the prospect of invoking the Section 13(3) powers. Chairman Powell’s response:

“We have nothing to announce on 13(3) powers…we’re prepared to use our authorities as is appropriate to support borrowing and lending in the economy, and hence to support the availability of credit to households and businesses.”

We still need major fiscal stimulus. We still need aggressive mitigation efforts. We still need resilience. But, before we believe that, now at zero interest rates, the Fed is out of ammunition, let’s remember Econ 101, monetary policy, “The central bank is the lender of last resort.”

Originally Posted in March 2020 – Repeat after me: “The Central Bank is the Lender of Last Resort”


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