We must be careful that the central bank’s drastic, necessary response to the current crisis doesn’t become an unsustainable new normal.
Ramesh Ponnuru, as usual, hit the nail on the head in his recent piece addressing the monumental task faced by the Federal Reserve, which must now prepare the economy to recover once the coronavirus crisis is over. His logic that inflation expectations are low, and that a greater supply of money would be therapeutic to the problem of falling wages and prices, is refreshing: Far too few conservatives understand the lost monetarism of Milton Friedman, and far too many of them adopt the platitudes of Rothbardianism without truly understanding monetary economics.
The Federal Reserve as a body has done a lot wrong in its 100+ years of existence, and conversations about reducing bubble/burst cycles and restoring the Fed to its role as a “lender of last resort” are always welcome. The underlying philosophical error embedded in the Phillips Curve, which stipulates an inverse relationship between unemployment and inflation, has done significant damage in compressing growth, as has the moral hazard of the “Fed put” (no longer named the “Greenspan put,” after Ben Bernanke and Janet Yellen gleefully took on the same role that originally earned it that moniker.) But recognizing the significant problems in the Federal Reserve’s execution of its charter does not make one Ron Paul.
Indeed, the Fed has an important role to play in our society, and Ramesh makes a thoughtful and cogent argument that it should fear inaction more than inflationary backlash just at the moment. I would take slight exception to his use of inflation-indexed Treasuries (TIPS) to infer market expectations for future deflation. I do not disagree with his conclusion, but the use of the implied inflation expectations in the TIPS market in March ignores what was a system-wide dislocation in fixed-income investments. Based on the long end of the yield curve — i.e., the yield of long-term treasury bonds — it is highly unlikely that the market decided after two weeks of the coronavirus scare and an oil-price drop that inflation would stay at 0 percent for ten years or longer. The more likely explanation of TIPS pricing in March was that a “run on assets” took place as investors scrambled for cash, the safest option, and that forced-liquidation period dislocated entire markets, from inflation-indexed Treasuries to AAA-rated municipal bonds to commercial paper — an event from which it’s difficult to draw macroeconomic lessons. Nevertheless, his underlying point remains important: Market actors fear and expect deflation more than inflation, and this gives the Fed a wide array of effective tools with which to respond.
The issue now facing the Fed is not one of dovishness vs. hawkishness. While President Trump was grossly out of line to state that Chairman Powell was “a bigger enemy of the people than [Chinese] president Xi,” there is little doubt that Powell’s eagerness to reduce the balance sheet in late 2018 hurt the market. The Fed’s prescription for the pains of the financial crisis was to stimulate the economy by any means necessary. It proved highly effective, which is not the same as declaring it successful or risk-free. As the Fed grew its balance sheet by roughly $4 trillion through three separate rounds of quantitative easing, roughly $4 trillion worked its way into credit markets, with significant new issuance in corporate-bond debt, syndicated bank loans, middle-market lending, and modest amounts of high-yield issuance. This new credit may not have been sitting on the balance sheets of America’s commercial and investment banks as the mortgage debt embedded in CLO’s and CDO’s was before the 2008 crisis, but $4 trillion had nevertheless been put into the economy by the Fed, and that money found its way to non-bank lenders who put it to productive use.
The key word in that sentence is productive. Debt-to-earnings ratios did not skyrocket because, well, earnings skyrocketed. Corporations took on leverage, to be sure — but not recklessly, certainly not recapitulating what built up in the financial system from 2004–2007. Nonetheless, the Fed wanted a re-levered corporate America, and they got it. Powell’s flirtations with hawkishness were rebuffed for that very reason — it was one thing to modestly normalize the benchmark interest rate, but to simultaneously take the punch out of the punch bowl of economy-wide liquidity was a bridge too far. Powell learned that lesson in January 2019, after markets threw up in December 2018, and he was forced to deal with not only Trump’s but the market’s chiding him into submission throughout the following year.
Fast-forward now to the coronavirus-induced economic downturn. Ramesh has asked the Fed to do what it can do, and indeed, the Fed appears to have proactively gotten the message. Besides the dramatic resumption of a zero-interest-rate policy, the central bank wasted little time in March signaling a renewed quantitative-easing project that will make its response to the financial crisis look tame. The Fed has purchased more than $1 trillion in assets, from Treasury bonds to mortgage-backed securities, in just the last few weeks. Creating brand new tools in the tool box, it has also prepared to back the aforementioned corporate-bond market, partnered with Treasury to lever up its equity capital in a new TALF (Term Asset Backed Securities Liquidity) facility, and even begun buying short-dated municipal-bond paper to assist highly dislocated municipal-bond markets.
Lender of last resort, indeed!
I do not wish to criticize the Fed for standing up in this moment, and I can’t imagine the gold bugs would have a very impressive playbook for dealing with the current shutdown of the U.S. economy. The efficacy of Fed intervention in financial markets has already begun to be validated, and will surely be further validated in significant ways in the months to come. But I wish to conclude with “years to come” commentary, not “months to come” commentary. The Federal Reserve has taken over everything from credit markets to the yield curve to the monetization of the federal debt. Though, as Ramesh points out, these maneuverings are perfectly defensible given the present emergency, we should not imagine that they’ll come without a cost.
Bagehot’s rule of the late 19th century was that a central bank would lend against good assets to provide liquidity to market participants, with disincentives for those needing cash to take them up on it. This is not the central-banking mantra of 2020. Central banks across the West have taken a page out of the Bank of Japan’s aggressive playbook, absorbing the burden of runaway debts that are never going to be paid. The downward pressure this promises to put on long-term growth is a problem of tremendous economic and moral import.
When this is all said and done, we must look objectively at the drastic fiscal and monetary measures we’ve taken and ensure that they don’t become a new, unsustainable normal in better times. After all, if dessert gets served after every meal, it is no longer a treat, is it?