COVID-19 Economic Downturn: What do cyclical norms suggest?

Business cycle downturns come in many forms. Some are big, others small. Some are long, others short. Some result from policy errors or euphoric booms, while others are the consequence of external events.

Nevertheless, downturns have some common features and regularities. Among those that have been reasonably stable over much of the past half century are the relationships among unemployment, activity and federal budget deficits. Using these, we explore the impact of the U.S. COVID-19 economic downturn that began last month.

To sum up, recent labor market developments already make clear that we are in the midst of the deepest recession since the 1930s. In fact, the coordinated shutdown of a large swath of the American economy has made this plunge more rapid than that of the Depression. Whether we are at the start of a second Depression depends greatly on how long we keep the economy in a state of suspended animation.

If the lockdown extends from weeks to months, the short-term pain will turn into long-term scarring. The longer it takes to reopen businesses safely, the more damage we will do to the many linkages and networks (including lender-borrower, supplier-user and employer-employee relationships) that make up the fabric of the economy. As the wave of bankruptcies grows, damage to the financial system will increase, as will the resulting harm to the economy’s productive capacity….

The Fed Goes to War: Part 3

For the second time this century, the Federal Reserve is a crisis manager. In this role, policymakers can lend to solvent but illiquid intermediaries (as the lender of last resort). They can backstop financial markets (as a market maker of last resort). And, when all else fails, they can take the place of dysfunctional private-sector intermediaries.

During the first financial crisis of the 21st century, the Fed’s response shifted from one role to the next as the crisis intensified. Yet, even compared to that massive crisis response, the Fed’s recent moves are breathtaking—in speed, scale and scope.

Indeed, with its most recent announcements on April 9, the Federal Reserve is committed to an unprecedented course of action to ensure the flow of credit to virtually every part of the economy. In carrying out its obligations under the newly enacted CARES Act, the Fed is effectively transforming itself into a state bank that allocates credit to the nonfinancial sectors of the economy.

Yet, picking winners and losers is not a sustainable assignment for independent technocrats. It is a role for fiscal authorities, not central bankers. Instead of using the Fed as an off-balance sheet vehicle for the federal government, we hope that Congress will shift these CARES Act obligations from the Federal Reserve to the Treasury, where they belong….

On the Resilience of Large U.S. banks

In the aftermath of the financial crisis of 2007-09, policymakers were intent on making the financial system able to weather an extremely severe storm. The authorities had two complementary goals: increase the financial system’s reliance on equity financing and enhance the ability of institutions to recapitalize themselves after a shock. Well, COVID-19 is upon us, and the shock looks to be bigger than the most adverse scenarios in supervisory stress tests.

Our view is that we have made limited progress in promoting resilience. In a recent post, we emphasized how COVID-19 economic disruptions are eroding banks’ capital buffers (that already were slim in parts of Asia and Europe). As the full impact economic and financial impact of COVID 19 becomes apparent, we suspect that some banks will need a form of recapitalization. They were not able to do this in 2008-09 on their own. Will this time be different …?

COVID-19 Stress Test

The COVID-19 shock is almost surely leading to a larger economic downturn than the Great Financial Crisis of 2007-09. However valuable, neither stress tests nor financial supervision in general has prepared us for a shock of this magnitude.

These developments leave us profoundly concerned that the global financial system lacks the resilience needed to weather what will clearly be a very violent storm. In our view, the most up-to-date information regarding the impact on the financial system of COVID-19 comes from NYU Stern Volatility Lab’s SRISK. By utilizing timely weekly market equity data, rather than less accurate and substantially delayed book-value information, SRISK enables us to gauge the aggregate shortfall of capital in the financial system during a crisis (defined as a 40 percent drop of the global equity market over the next six months). Analogous to a severe stress test, the idea behind SRISK is that an intermediary contributes to fragility to the extent that it is short of capital at the same time that there is a system-wide shortfall (see, for example, here). Just as a forest is more vulnerable to fire during a drought, so the financial system is more vulnerable to a large shock when there is a large aggregate capital shortfall.

In the remainder of this post, we highlight some recent SRISK developments and compare them to those during the 2007-09 crisis. We view these developments as a clear warning to regulators and supervisors that the COVID-19 shock meaningfully threatens financial stability across major jurisdictions….

The Fed Goes to War: Part 2

In this note, we update our earlier comment on the first set of Fed actions that appeared on March 23 just as a slew of new ones arrived.

While most of the changes represent simple extensions of previous tools, the Fed also has introduced facilities that are going to involve it deeply in the allocation of credit to private nonfinancial firms. Choices of whom to fund are inherently political, and hence destined to be controversial. Engaging in such decisions will make it far more difficult for the Fed eventually to return to the standard of central bank independence that it has guarded for decades. We urge the Fed to limit its involvement in the allocation of credit to the private nonfinancial sector. And, should Congress deem it necessary, we encourage them to provide explicit authorization to the Treasury (along with the resources) to take on this crisis role.

The Fed Goes to War: Part 1

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.

The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.

In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand….

COVID-19: What can monetary policy do?

Two weeks prior to their regularly scheduled mid-March meeting, the members of the Federal Open Market Committee (FOMC) voted unanimously to cut their target policy rate by 50 basis points to the 1 to 1¼ percent range. Policymakers attributed their exceptional decision to the “evolving risks” posed by the coronavirus. This move was the first inter-meeting policy rate shift, and the largest cut, since late 2008, at the depth of the financial crisis. Moreover, this time the move came against the background of a strong economy. Nevertheless, based on futures prices, market participants anticipate a further 75-basis-point cut in the target federal funds rate this month!

The coronavirus has thrust us into uncharted territory. Do central bankers really have any tools to guide us back to safer ground?

In the remainder of this post, we discuss the importance for policymakers of distinguishing between shocks to aggregate supply and demand. Importantly, while monetary policy can combat demand shocks, it can do nothing to cushion the impact of reductions in supply without sacrificing the commitment to price stability. The coronavirus shock involves some as-yet-unknown mix of these two very different types of shocks. Yet, given the limited amount of conventional policy space, and the decline of long-term inflation expectations, there is a good case for the FOMC to act rapidly and aggressively….

Contagion: Bank Runs and COVID-19

There are currently more than 85,000 confirmed cases of COVID-19 in at least 60 countries. Yet, we know very little about this pathogen, except that everyone is worried. And, with the number of cases rising each day, intensifying concerns probably will lead many people to behave in ways that undermine economic activity. They will shy away from places where the virus can be transmitted. That means avoiding mass transit, schools, and workplaces.

Moreover, many people will stay away until they are confident that the disease is manageable. That confidence probably requires an effective treatment, a very low likelihood of infection, or both. Not surprisingly, many observers are reducing their projections for economic growth this year, while financial market participants anticipate easier monetary policy to cushion the shock.

The challenge of re-establishing public confidence that it is safe to venture out bears striking similarity to the one that authorities face in stemming a bank run. Our ability to identify and quarantine people infected with COVID-19 is analogous to our ability to recognize and isolate a bank bordering on insolvency. This and other similarities suggest that the means we use to control bank runs also may be useful in managing the economic consequences of an emerging pandemic like COVID-19….

Bank Runs and Panics: A Primer

A bank promises its clients immediate access to cash. Depositors can redeem their funds on demand at face value—first come, first served. Other short-term creditors can do the same, albeit at varying speeds, by not rolling over their loans. And, households and firms that pay a fee for a credit commitment can take down their loans at will.

For banks that hold illiquid assets, these promises of liquidity on demand are the key source of vulnerability. The same applies to other financial institutions (de facto or shadow banks) that perform bank-like services, using their balance sheets to transform illiquid, longer-maturity, risky assets into liquid, short-maturity, low-risk liabilities.

A bank run occurs when depositors wish to make a large volume of withdrawals all at once. A bank that cannot meet this sudden demand fails. Even solvent banks—those whose assets exceed the value of their liabilities—fail if they cannot convert their assets into cash rapidly enough (and with minimal loss) to satisfy their clients’ demands. A banking panic is the plural of a bank run: when clients run on multiple banks. We call the spread of runs from one bank to others contagion—the same term used to describe the spread of a biological pathogen.

In this primer, we characterize the sources of bank runs and panics, as well as the tools we use to prevent or mitigate them….

Monetary Policy in the Next Recession?

In many advanced countries, lowering the policy rate to zero will be insufficient to counter the next recession. In the United States, for example, with the target range for the federal funds rate at 1½ to 1¾ percent, there is little scope for the nearly 5 percentage-point easing that is typical in recent recessions (see, for example, Kiley).

This is the setting for this year’s report for the U.S. Monetary Policy Forum, written with Michael Feroli, Anil Kashyap and Catherine Mann. Our analysis focuses on the extent to which the “new tools” of monetary policy—including quantitative easing, forward guidance and negative interest rates—have been associated with an improvement of financial conditions. The idea is that the transmission of monetary policy to economic activity and prices works primarily through its effect on a broad array of financial conditions.

The USMPF report does not challenge the views of many researchers and of most central banks that the new monetary policy (NMP) tools have an expansionary impact even at the effective lower bound for nominal interest rates (see also the 2019 report from the Committee on the Global Financial System). However, we find that these new tools generally were not sufficient to overcome the powerful headwinds that prevailed in many advanced economies over the past decade.

Our conclusion is that central bankers should clearly incorporate the new tools in their reaction functions and communications strategies, but should be humble about their likely success in countering the next recession, at least in the absence of other supportive actions (such as fiscal stimulus)….

Commentary

Money, Banking, and Financial Markets