First of three posts
The Federal Reserve’s response to the coronavirus pandemic has been unprecedented in its size and scope. In a matter of months, the Fed has, among other things, cut the federal funds rate to the zero lower bound, purchased a large amount of Treasury securities and agency mortgage‑backed securities (MBS) and, together with the U.S. Treasury, introduced several lending facilities. Some of these facilities are very similar to ones introduced during the 2007-09 financial crisis while others are completely new. In this post, we argue that the new facilities, while unprecedented, are a natural extension of the Fed’s toolkit, as they operate through similar economic mechanisms to prevent self-reinforcing bad outcomes. We also explain why these new facilities are particularly useful as part of the response to the pandemic, which is an economic shock very different from a financial crisis.
An Overview of the Facilities
The distinction between new and old facilities loosely maps to a commonly used description of facilities as “liquidity” or “credit” facilities. Liquidity facilities include the Primary Dealer Credit Facility (PDCF), the Commercial Paper Funding Facility (CPFF), and the Money Market Mutual Fund Liquidity Facility (MMLF). These facilities support financial intermediaries, such as primary dealers and money market funds, or money markets, such as the commercial paper market. In addition, they provide short-term support, generally less than one year. “Credit” facilities include the Municipal Liquidity Facility, the Main Street Lending Program, the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF), the Term Asset‐Backed Securities Loan Facility (TALF) (introduced during the 2007-09 crisis) and the Paycheck Protection Program Liquidity Facility (PPPLF). They support corporations, states, and municipalities more directly and the terms of the loans are longer. All these facilities were established under Section 13(3) of the Federal Reserve Act, with approval of the Treasury Secretary.
Regardless of the label used to describe these facilities, they all serve a similar purpose, to ensure that American businesses and households have access to credit. Moreover, we argue that they do so through a similar economic mechanism; stepping in to ensure that, when there are multiple possible economic outcomes, the U.S. financial system is positioned to facilitate the best possible outcome for the U.S. economy.
How do Federal Reserve facilities help the financial system?
Liquidity provision by the central bank can break the vicious cycle that makes panics self-fulfilling. For example, in a bank run, if a bank can borrow from the central bank to repay its depositors, it will not have to sell its assets at a loss. This means that the bank will have enough resources to repay the depositors that are not withdrawing immediately, which reduces or eliminates the incentive to do so. This is an example of multiple equilibria—a situation with multiple outcomes. By acting according to Walter Bagehot’s advice to the Bank of England to lend freely and vigorously against good collateral, the Fed can prevent or mitigate run dynamics.
In the 2007-09 financial crisis, the liquidity facilities were established to help prevent run dynamics in financial markets, just as the Fed has done through the discount window for banks since its founding, thus avoiding the bad equilibrium that could follow from inefficient fire sales of assets. Many of these facilities have been reinstated to respond to the severe market dislocations and run risks that emerged in response to the coronavirus pandemic.
Are “credit” facilities a new role?
At first glance, the “credit” facilities appear new to the central bank’s tool kit, targeting businesses and localities directly rather than providing liquidity to banks and financial markets. When the cause of lack of access to credit is fundamental uncertainty about the real economy, we argue that, just as the Fed steps in to lend to solve the multiple equilibria facing banks in a run, the “credit” facilities help solve a multiple equilibria problem facing the real economy. In this way, the facilities are a natural evolution of the toolkit adapted to the current circumstances.
A growing literature in economics theorizes about the possibility of multiple equilibria in the real economy. For example, if households and firms have pessimistic views about the future, they are likely to be reluctant to consume and invest. This will in turn depress economic activity. Conversely, if households and firms have optimistic views about the future, they will be willing to consume and invest and this will in turn stimulate economic activity (see, for example, this Liberty Street Economics post). This literature also suggests that in models with multiple steady-states, a self-reinforcing negative outcome is likely to happen only in unusual circumstances, for example, following an unusually large shock (as in Benigno and Fornaro). This possibility of multiple equilibria is also explored empirically in Adrian, Boyarchenko, and Giannone. They estimate forecasts in a framework that allows for negative feedback between ever-tighter financial conditions and slowing growth. The authors apply this estimation in a recent blog post and show the prospect of two possible outcomes, a more benign outcome and a very negative one in 2020. The possibility of multiple equilibria is rare in their framework but was also evident in 2008.
It is important to recognize that the coronavirus pandemic is of a different nature than the 2007-09 financial crisis. That crisis was primarily a financial shock that amplified what may have otherwise been a reasonably small macroeconomic shock. By contrast, the pandemic is primarily a large macroeconomic shock arising from measures taken to contain it. The shock to the economy created by the pandemic has created unusually high uncertainty about the possible macroeconomic outcomes, affecting companies and localities that rely on capital markets. This can arise when financial markets assign too much weight to negative outcomes that good policy can avoid. As a result, market prices will diverge from what they would be under the better equilibrium. Since the multiple possible economic outcomes affect mainly the real economy, and are driven by uncertainty about the prospects for the post-shutdown economy rather than financial institutions, the Fed had to adapt its tools to address this new problem.
The multiple equilibria argument does not mean that these facilities are a free lunch—costlessly leading the U.S. economy to the better outcomes. Interventions could raise concerns, particularly about moral hazard, as we discuss in a later post.
A Joint Effort
As noted by Fed Chair Jerome Powell during a Brookings webinar, the Fed is providing “credit to households, businesses, state and local governments as we are directed by the Congress.” In theory, if the Fed knew with perfect certainty the length of the COVID-19-related disruptions and the state of the better equilibria for the economy, no capital would be required to extend these facilities. However, in practice, given their unconventional natures, and the scale of the required intervention, the facilities have been established in partnership with the U.S. Treasury. To provide a large-enough backstop at reasonable prices, the Fed in particular relies on the equity that the U.S. Treasury provides to protect it from losses on the “credit” facilities as mandated in the CARES Act and in Section 13(3) of the Federal Reserve Act. In addition, Section 13(3) requires that the Secretary of the Treasury approve any Section 13(3) facility established by the Fed.
The Fed plays two important roles in this partnership. First, it leverages the capital that Treasury is putting toward helping the real economy. This means that the amount of support available to households, businesses, state and local governments is larger than it otherwise would be. Second, the Fed provides technical and operational expertise to help set up these programs as fast as possible so that relief is available quickly to those who need it.
To Sum Up
A central bank’s toolkit must adapt to the circumstances it faces. The Fed has established a number of facilities, in partnership with the Treasury and at the direction of the Congress. These facilities play a similar role to that played by the facilities introduced during the 2007-09 financial crisis, helping to prevent self-reinforcing bad outcomes. The “credit” facilities are particularly helpful to respond to the macroeconomic shock created by the uncertainty associated with the coronavirus pandemic. Of course, the facilities are only one aspect of the official sector’s response to the pandemic. In tomorrow’s post, we consider interventions by the official sector more broadly, including institutions like the Treasury and Congress, asking whether, during the pandemic, they should extend support to insolvent businesses.
Anna Kovner is a policy leader for financial stability in the Federal Reserve Bank of New York’s Research and Statistics Group.
Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.
How to cite this post:
Anna Kovner and Antoine Martin, “Expanding the Toolkit: Facilities Established to Respond to the COVID-19 Pandemic,” Federal Reserve Bank of New York Liberty Street Economics, September 22, 2020, https://libertystreeteconomics.newyorkfed.org/2020/09/expanding-the-toolkit-facilities-established-to-respond-to-the-covid-19-pandemic.html.
Related Liberty Street Economics reading
Market Failures and Official Sector Interventions
The Official Sector’s Response to the Coronavirus Pandemic and Moral Hazard
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.