America’s central bank, the Federal Reserve, responded to the crisis with its biggest ever policy programmes. But the measures have had contrasting effects to date: while the corporate bond market has improved, credit conditions for smaller firms reliant on banks remain tight.
In the second quarter of 2020, the US economy recorded its steepest quarterly drop in economic output since comparable records began (the post-war period). On 8 May, the Bureau of Labor Statistics reported the official unemployment figure of 14.7%, the highest level recorded since 1941, with an unprecedented 20 million jobs lost in April alone. On 30 July, the Bureau of Economic Analysis reported that US GDP in the second quarter fell at an annualised rate of 33% – around 8% in that quarter alone.
Such a dramatic contraction in economic activity may push available monetary policy responses to the limit. This article examines the implications, drawing on Arvind Krishnamurthy’s recent presentation at the Money Macro & Finance Society policy conference on ‘Financial Stability Implications of Covid-19’.
What has the Fed done to stimulate economic activity?
Traditionally, a central bank’s response to a negative shock to demand is an interest rate cut. The US Federal Reserve (known as ‘the Fed) did exactly that by cutting the overnight interbank lending rate twice in as many weeks by a total of 1.5 percentage points, bringing it close to zero by 15 March.
Yet in the current economic environment, the Taylor rule – a mechanical formula that specifies the optimal interest rate response to changes in inflation and output – would have called for an overnight rate in the range of negative 7%. Such a level would be unfeasible since even though the effective lower bound for interest rates is below zero, it is not possible to drive them to such low levels: investors and banks would prefer to hold cash instead, which at least pays 0%. Put differently, the Fed’s firepower is constrained and its policy rate is far from its optimal level given this shock.
To provide further stimulus to the economy, the Fed relaunched many of the unconventional policies that were first adopted during the global financial crisis and Great Recession of 2007-09. In particular, the Fed has indicated via speeches and statements that it will keep interest rates at near zero for the next few years.
This type of policy, known as ‘forward guidance’, aims to boost aggregate demand by influencing the private sector’s expectations of future policies – which, in turn, reduces long-term interest rates, easing the current borrowing conditions faced by households and firms (Woodford, 2013).
The Fed also reactivated its ‘quantitative easing’ (QE) programme, buying $80 billion of long-term Treasury bonds and $40 billion of mortgage-backed securities (MBS) per month. QE, which was widely used in response to the global financial crisis, entails purchases of long-term government securities to push up their prices. Given that interest rates are inversely related to bond prices, this reduces interest rates, easing current financial conditions.
Research finds that QE has helped to lower interest rates, with the largest impact on long-dated safe assets that are near substitutes for Treasury bonds and MBS (Krishnamurthy and Vissing-Jorgensen, 2011). The purchases of long-term Treasury bonds are likely to have reduced their interest rates by around 0.6% (Vayanos and Vila, 2020).
On the other hand, the US Treasury has run a sequence of fiscal deficits funded by more debt issuance, which is likely to have offset some of this impact (the federal deficit reached 17.9% of GDP in 2020, more than double the rate at the height of the global financial crisis in 2009).
Related question: Quantitative easing and monetary financing: what’s the difference?
What has the Fed done to support credit markets?
There is a risk of long-lasting ‘scarring’ of the economy due to potentially lower investment, innovation or human capital, which could forestall recovery once the pandemic is over. To prevent this, the Fed has introduced new tools intended to provide liquidity to firms and ensure their continued access to funding.
In March 2020, the Fed announced two new programmes:
- The Corporate Bond Program aims to improve liquidity conditions in the corporate bond market through the purchase of corporate bonds, either directly from non-financial firms or indirectly on secondary markets.
- The Main Street Lending Program aims to support lending to small and medium-sized enterprises (SMEs, both for-profit and non-profit) that were in sound financial condition prior to the pandemic. To boost bank lending to these enterprises, the Fed has committed to buy 95% of new or existing loans, with the issuing bank keeping the remaining 5%. The restrictions on leverage and the ‘skin-in-the-game’ requirement for banks ensure no credit subsidy. This programme also requires that the borrowers retain workers on the payroll, in line with the overall aim of keeping businesses operational and maintaining employment.
Related question: How did central banks respond to the coronavirus crisis?
Did the Fed succeed in supporting credit markets?
The corporate debt market suffered a severe dislocation in March 2020. Research suggests that bond prices plummeted more than what could be attributed to default risk, especially for safe firms (Haddad et al, 2020). As investors rushed to cash in their bonds, the most liquid ones were sold first, putting significant downward pressure on their prices (O’Hara and Zhou, 2020).
The Fed’s announcement of a corporate bond purchase programme has short-circuited this liquidation spiral, backstopping the corporate debt market. Yields on corporate bonds rapidly decreased after the announcement of the Corporate Bond Program on 23 March, fully stabilising by mid-May (see Figure 1). On the other hand, credit terms for bank-dependent borrowers have remained tight.
Figure 1: Percentage of banks tightening loan standards versus high yield bond spreads (2000-2020)
A tale of two markets?
Even though the Fed’s purchases of corporate bonds are small relative to the size of issuance ($75 billion against $1.919 trillion of total corporate bond issuance in 2020), the corporate debt market has stabilised, with bankruptcy counts remaining low given the severity of the shock. In addition, many bankruptcies have taken the form of Chapter 11 reorganisations – the US bankruptcy code allowing companies the continuity of operations – minimising the risk of scarring.
In contrast, credit terms for bank-dependent borrowers have been tight (see Figure 1). The Fed’s Senior Loan Officer Opinion Survey indicates a tightening of lending to small firms, principally due to concerns about borrowers’ business/industry outlook. Scarring concerns remain present for both the SMEs sectors, although distress in the former remains low, likely thanks to the Paycheck Protection Program – a lending scheme specifically targeting small businesses.
Indeed, the contrast in credit terms between the corporate bond market and the bank lending market, measured by the difference between the two lines in Figure 1, is starker than it has been at any time over the last 20 years. Corporate bond spreads and rates on credit default swaps are now at pre-Covid-19 levels. Yet as noted, the Fed’s bond purchases are relatively small.
Covid-19 and public health policy response have precipitated ‘a crisis like no other’, posing unprecedented challenges to economic policy-makers across the globe. The Fed’s swift response matched the scale of the crisis, with programmes larger than any it has deployed in the past (although the US Treasury has recently refused to extend several of the Fed’s lending facilities).
But the impact of the Fed’s actions has been felt differently across the credit markets. While the corporate bond market has improved, credit conditions for bank-dependent borrowers have remained challenging, potentially limiting the effectiveness of monetary policy.
Where can I find out more?
- What is quantitative easing? An explanation by the Bank of England.
- How is Covid-19 different from other crises in the past? Q&A session on the Covid-19 crisis with David C. Wheelock, Group Vice President of the Federal Reserve Bank of St. Louis.
- Policy responses to COVID-19: International Monetary Fund policy tracker that summarises the key economic responses governments are taking to limit the human and economic impact of the COVID-19 pandemic.
- Negative interest rate policy in the post COVID-19 world? VoxEU article by Andrew Lilley and Kenneth Rogoff about negative interest rate policy.
- Rethinking monetary and fiscal policy in the post-Covid euro area Monetary Dialogue Paper, The European Parliament.
- Corporate debt overhang and credit policy, Brookings Papers on Economic Activity by Markus Brunnermeier and Arvind Krishnamurthy.
Who are experts on this question?
- Gianluca Benigno
- Laura Coroneo
- Oliver de Groot
- Arvind Krishnamurthy
- Michael McMahon
- Gulcin Ozkan
- Ricardo Reis
- Silvana Tenreyro