Analysis & Opinions - Belfer Center for Science and International Affairs, Harvard Kennedy School

How is the U.S. Federal Reserve Responding?

| Apr. 07, 2020

The Fed’s response is directed toward achieving three goals: preventing financial markets from breaking down and magnifying the crisis; supporting domestic businesses through economic turbulence which could result in wide-spread bankruptcies; and ensuring that foreign central banks in major economies have access to dollar liquidity.

  • The Fed has deployed its entire 2008 crisis playbook in a matter of weeks. Domestically, the response includes dropping interest rates to zero and purchasing a variety of assets. However, monetary policy is likely to have a limited impact this time around, given that businesses are shuttered and large parts of the economy have ground to a halt. 
  • Unlike the 2008 crisis when the focus of Fed policies was on financial institutions, the Fed needs to shore up main street and local governments. Policy proposals include indirect support for municipal governments -- by shoring up money market mutual funds that invest in these assets -- and lending directly to small and medium enterprises. However, more direct support is needed both to local and state governments that are on the front lines of the crisis as well as “main street” businesses that have seen an evaporation in customer demand. 
  • All the crisis-era international coordination mechanisms are back in play. The Fed has opened swap lines to foreign central banks, and created a facility to allow central banks to access dollar liquidity by pledging their reserves of U.S. Treasuries. 

Below, we take a look at the emerging policy decisions from the Federal Reserve.

How is the Fed supporting domestic financial markets and businesses?

Although the public health crisis originated outside the financial system, financial markets are suffering a similar breakdown as in the 2008 financial crisis. The Fed’s playbook features most of the tools it used to shore up financial markets and institutions in 2008. But the Fed has also launched new initiatives focused directly at aiding businesses, such as intervening in the corporate bond market. Major actions the Fed has taken so far include:

  • Cutting interest rates to zero. Lower interest rates make it cheaper and easier for borrowers to access credit in order to survive the economic shock. Unlike in 2008, however, when rates started as high as 5.25%, rates going into this downturn were already low, at 1.75% at the start of 2020. Since the scope of further reductions is limited, the Fed has introduced a broader set of measures to try to ensure the flow of credit.
  • Restarting Quantitative Easing, but now in unlimited quantities and in broader asset classes. During the 2008 crisis, the Fed purchased $3.7 trillion of Treasury bonds and mortgage-backed securities (MBS) to supply the market with liquidity and keep interest rates low. It has restarted this program in response to the COVID-19 crisis. The Fed first pledged to purchase at least $700 billion of Treasuries and MBS, but has since indicated it would purchase in unlimited quantities. Additionally, the Fed broadened the range of assets it would purchase to include commercial MBS. By purchasing these securities, the Fed adds new money to the economy, which encourages lending and investment. Increasing the supply of money also reduces the cost of money (interest rates), but as discussed above, this impact is limited in an already low-rate environment. 
  • Supporting large employers by purchasing commercial paper, corporate bonds and lending to corporates directly. The Fed restarted the crisis-era Commercial Paper Funding Facility (CPFF) to purchase commercial paper (short term funding issued by corporates and other entities) that was being sold off by investors in a flight to safety. Whereas during the 2008 crisis, the $348 billion facility backstopped only asset-backed commercial paper (ABCP), a broader range of commercial paper is eligible under the current facility. 

    Another crisis-era program, Term Asset-Backed Securities Loan Facility (TALF), has also been restarted to support consumer and small business needs. Under TALF, the Fed offers loans against collateral, including student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. In the financial crisis, TALF provided $48 billion worth of funding, whereas during the current crisis the Fed plans to make up to $100 billion of loans available.

    The Fed has also announced two programs to support corporate debt markets directly, a new step for the central bank. The Primary Market Corporate Credit Facility (PMCCF), which will purchase newly-issued corporate debt, and the Secondary Market Corporate Credit Facility (SMCCF) which will backstop existing corporate debt to keep rates down.
  • Backstopping money market mutual funds and supporting municipal credit markets. The Fed established a $10 billion Money Market Mutual Fund Liquidity Facility (MMLF), which provides loans to banks secured by high-quality assets that banks have purchased from money market mutual funds. The facility is intended to relieve pressure on money market mutual funds, which take in deposit-like funds and invest in highly liquid assets such as commercial paper. As concerned investors withdraw money in crises, money market mutual funds are forced to sell assets to meet redemptions, further depressing prices and driving up rates.

    The current MMLF is similar to a 2008 facility, except the Fed will now extend loans to banks against highly rated municipal debt as collateral. In addition to supporting money market mutual funds, the facility indirectly supports local governments by incentivizing banks to buy local debt. As city and state governments will be on the front-line of responding to the public health crisis, stability and cheap funding in muni markets is a priority.
  • Encouraging banks to lend. The Fed has broadly relaxed requirements on banks to hold capital reserves, such as total loss absorbing capacity (TLAC), encouraging them to lend to businesses instead. The Fed also encouraged banks to access the “discount window,” a source of lender-of-last-resort funds that banks have been hesitant to use for fear of appearing undercapitalized. In a collective effort to dispel the stigma, the Financial Service Forum (which includes large banks such as Bank of America and JP Morgan) announced all its member banks would be accessing the discount window facility.
  • Proposing a lending scheme for small and medium-sized enterprises. In an unprecedented step, the Fed also announced that it would create a Main Street Business Lending program. The program would aim to provide loans to small and medium enterprises. Funding is expected to be in part appropriated by Congress through the stimulus bill in response to the crisis.

How is the Fed supporting international markets and U.S. allies?

The dollar functions as the world’s reserve currency. Internationally, banks and other institutions that transact, borrow and lend in dollars face challenges when dollar liquidity dries up, such as during the current crisis. 

In response, the Fed strengthened and expanded its existing swap lines with other key central banks to provide dollar funding abroad. The Fed also unveiled a new facility aimed at providing additional dollar liquidity to global markets through repurchase agreements, the Temporary Facility for Foreign and International Monetary Authorities (FIMA).

What are swap lines and how do they support global markets?

Through swap lines, the Fed provides U.S. dollars to a foreign central bank, in exchange for an equivalent amount of foreign currency. The foreign central bank can then disperse these dollars to financial institutions in its jurisdiction. The swap is conducted at the market exchange rate and the central banks agree to swap back their currencies on a predetermined future date at a preset rate, removing exchange rate and other market risks. These swap lines were a critical tool for managing the prior crisis, and some have stayed in place to this day.

The primary goal of swap lines is to stabilize foreign markets, since distress abroad could spillover to the U.S. For example, foreign holders of U.S. assets — such as Taiwanese insurers, which hold 4% of U.S. corporate debt — might be forced to sell off their holdings in a firesale were funding to become scarce. That could trigger turmoil in U.S. credit markets.

To combat the current crisis, the Fed, acting in coordination with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank, reduced funding costs on dollar swaps by 25 basis points. It also increased the maturity to 84 days from the standard one week. The Fed later extended swap lines to more central banks, including those of Australia, Brazil, Denmark, South Korea, Mexico, Norway, New Zealand, Singapore and Sweden.

What is the new Temporary Facility for Foreign and International Monetary Authorities and how does it differ from swap lines?

Swap lines solve part of the dollar liquidity problem, but central banks in economies that are facing or could face significant dollar needs, such as China, do not have access to Fed swap lines. To address these needs, the new FIMA facility allows central banks (and international organizations) to pledge U.S. Treasury holdings as collateral in exchange for dollars from the Fed.

Central banks with significant U.S. Treasury holdings will be able to address dollar needs through the facility, although countries with limited reserves such as South Africa and Turkey may still struggle to secure dollar liquidity.

The facility also has the benefit of helping to stabilize the U.S. Treasury market. By allowing foreign central banks to offer their Treasury holdings to the Fed instead of in open markets, the Fed aims to calm the volatile sell-off of Treasuries that occurred earlier in March.

Sources and further reading:

For more information on this publication: Belfer Communications Office
For Academic Citation: Cassetta, John Michael and Aditi Kumar.“How is the U.S. Federal Reserve Responding?.” Belfer Center for Science and International Affairs, Harvard Kennedy School, April 7, 2020.

The Authors