Tuesday, March 17, 2020

No, The Federal Reserve Didn't Give 1.5T to Bank's. Yes, It's The Right Thing To Do

A few days ago the Federal Reserve launched a large scale Quantitative Easing program that, for some reason, is being used as a justification to finance large spending programs. To be clear, the Federal Reserve did not lend a bank a penny, they simpled lent them short term loans.

The 1.5T is essentially a short term loan operation in exchange for a participant's most liquid asset. The loans are used by banks to stabilize their balance sheets so that no one worries about the viability of the bank(as the systemic risk would be a huge structural problem). Once the loan is paid back the money is essentially destroyed and the Participants get their assets back. Since all the loans are collateralized, the Fed would rain financial hell on whoever doesn't pay back the loans. (Currently at 3-month maturity)

The economic equivalent of the Fed doing this for everyday people would be them giving us a lump sum of money and expecting us to pay it back the next day with high interest, something that's obviously not desirable. If we didn't, they'd take our house. Except, it's even worse than that.  It’s more like an exploitative pawnshop owner already took your $350 watch gave you $300 and said if you don’t show up with $330 in 48 hours, he keeps the watch. Except it’s not even a watch, it’s a fairly liquid stable asset.

Lastly, of course this is the right thing for the Federal Reserve to do. The Fed follows and accommodates the natural rate of interest. Even though the corona pandemic is a supply-side shock, it has negative demand-side expectations for the economy. This causes the natural rate of interest to fall. Had the Fed not been expansionary enough, monetary policy would become too tight and a recession would happen.

That being said, there's still more the Fed can do.

They can ask Congress to buy a wider range of assets.

They can stop paying IOER. (They lowered it to 0.1%)

And they can adopt a level target. Preferably, a nominal GDP level target.