Global central banks are changing their playbooks to respond to the COVID-19 outbreak, adopting unprecedented monetary-policy tools.
The pandemic came at a time of near-zero interest rates, forcing many central banks, including the Federal Reserve, to resort to purchases of long-term assets (“quantitative easing” or “QE”). Central banks with negative interest rates like the European Central Bank and Bank of Japan have had to rely particularly heavily on unconventional monetary-policy tools.
Critics and supporters spent the past decade debating the effectiveness of these interventions and the risks they entail, with some worrying that ballooning bank reserves would spur inflation. As during the first three rounds of QE, those criticisms ring hollow. Instead, asset purchases have successively staved off the worst-case recession scenarios and prevented a deflationary spiral.
QE aims to lower borrowing costs for corporations and homeowners, thereby stimulating the economy by preserving access to credit. During the Great Recession, most central banks only bought government bonds and government-sponsored mortgage-backed securities (MBS).
This time around, as predicted by some economists before the crisis, old-style QE has proven less effective, fueling a greater dependence on fiscal policy to deal with the consequences of the lockdowns.
For instance, the Fed announced it would buy an unlimited amount of Treasuries and MBS on March 23, 2020, but the 10-year yield on U.S. Treasury bonds fell only 16 basis points on the following trading day. This drop is smaller than the 22 basis point impact of QE1 announced in November 2008 and the cumulative effect of QE2 announced in late 2010 of 30 basis points.
After March 23, the Fed announced other new programs, including purchases of risky assets such as investment-grade and high-yield corporate bonds.
Corporate-bond purchases have proven very effective at reducing borrowing costs. On the day of the announcement, the S&P 500 bottomed out and corporate-credit yields peaked. A few days later, the Fed announced it would even buy junk bonds, which carry much greater default risk than government bonds. The following day, the prices of these assets soared.
Many rightly criticize central-bank buying of corporate assets for potentially creating “moral hazard,” giving firms the incentive to take greater risk on the assumption that the Fed will step in to the rescue them when the losses materialize. In March, however, the Fed intervened to mitigate the side effects of an unforeseen pandemic, as opposed to bailing out firms from the consequences of their own behaviors.
Another important concern with QE is that it can be inflationary. The notion is that if the government issues large amounts of money to buy a fixed supply of goods, prices need to rise. The new form of QE preserves credit to firms to continue their production, and supports both demand and supply. It is therefore unlikely to be inflationary.
A third criticism is that corporate-bond purchases waste taxpayer money. To the contrary, it is likely that such purchases will ultimately save the government money, as they did during the Great Recession. Boeing, which at one point was looking for a government bailout, ended up being able to raise capital from the markets at reasonable cost after the Fed began its corporate-bond purchase program.
Because the market for government bonds and MBS is large and liquid, even large purchases by the Fed are bound to have limited impact on yields and are quickly offset by portfolio adjustments in the private sector. When liquidity evaporates in the smaller markets for corporate credit, acting as a buyer of last resort is a powerful pushback against expectations of free-falling prices and can have much larger knock-on effects.
QE in the form of government asset purchases has had a limited and declining effect on yields over time. Faced with a new crisis, the Fed rewrote its playbook with new QE programs of corporate-asset purchases. We will likely debate the why and the how of these new interventions for years to come. But the early signs are that they revived the corporate-credit market from the COVID heart attack. One can now only hope that the recovery is as rapid as possible.