The Fed’s Role During the Pandemic
Federal Reserve Board Chairman Jerome Powell and Treasury Secretary Stephen Mnuchin following a hearing held by the House Committee on Financial Services (Philadelphia Inquirer).
By Mitchell Simoes
The coronavirus pandemic has had a historic impact on the U.S. economy. In March the labor market saw a 60% decrease in total hours worked, in April the U.S. personal savings rate reached its highest ever recorded level, and by July over 420,000 small businesses failed. And the pandemic’s accompanying restrictions and feelings of uncertainty have only added fuel to the great economic downturn we’re seeing now. In light of this, the government and other U.S. institutions have been active in combating the economic effects of the pandemic. But recently, in response to disappointing data on the latest job growth trends, Federal Reserve Bank of Chicago President Charles Evans stated that he won’t yet call for any further changes in monetary policy. He said instead that government aid will be most effective in supporting the economy. The Chair of the Federal Reserve, Jerome Powell, also recently showed his support for fiscal policy, saying how monetary policy has its role but that a fiscal response is crucial as well. With two leaders of the Fed advocating for fiscal policy over additional monetary action, it may well seem like they are doing nothing right now. Which begs the question – should the Fed be doing more?
First, we must recognize that the Fed has been taking action during the pandemic and has done a lot to mitigate its devastation on the economy. They have lowered interest rates to near-zero and given guidance that they will remain low until the economy restabilizes. By doing so they are encouraging borrowing in an effort to keep people spending and stimulate the economy. Along with this, the Fed has engaged in open market operations, growing their portfolio of securities held outright from $3.9 trillion to $6.1 trillion between March and June. In addition to these two traditional modes of monetary policy, the Fed has established several other initiatives with the goal of making money and liquidity more accessible to banks, businesses, and citizens. Some of these initiatives include offering low interest rate loans to financial institutions in order to keep credit markets functioning, directly lending to state and municipal governments, providing affordable loans to nonprofit organizations like schools and hospitals, encouraging banks to dip into capital and liquidity buffers, and even directly lending to businesses small and large. All of these initiatives have worked to stimulate the economy and soften the blow that COVID-19 has dealt.
With all the effort that the Fed has committed so far, it seems like it would only make sense for them to keep going, not to take foot off the pedal as Evans and Powell seem to be suggesting.
But there are some limitations to monetary policy that should be taken into consideration. When it comes to affecting the interest rate during a recession, the Fed is bound by how low they can really bring it. With an interest rate already hovering around 0.25%, there isn’t much more room to go down until it reaches zero. The possibility exists of even going into the negatives, but that strategy is unpredictable and is only just starting to be experimented with around the world. Another major concern surrounding low interest rates, even at the current levels, is the risk of hyperinflation. This can occur when interest rates are too low as it leads to over-borrowing at artificially low prices, creating a speculative bubble in which prices rise rapidly as a result of expectations rather than actual growth. If this rise in prices is not supported by GDP growth, hyperinflation occurs, and this can spiral out of control very quickly. Along with these risks, it should be noted that a lot of the short-run effectiveness of monetary policy is inconclusive and heavily disputed. As described by the Federal Reserve of St. Louis, “it is neither reasonable nor desirable” to attribute short-term changes in inflation, good or bad, to monetary policy because there are too many factors that can shock an economy in the short run. For this reason, it seems better to employ monetary policy for longer-term goals since there is a time lag to its effects.
With that in mind, we turn to Evans and Powell’s recommendation: fiscal policy. Fiscal policy is the bag of tools that the government has for the purpose of regulating the economy, consisting mainly of government spending/aid and taxes. As Evans points out, fiscal policy can be more pointed and direct than monetary policy, targeting specifically afflicted industries and regions. By spending on the industries that need it the most, the government can give the necessary attention to those most affected by the pandemic, a power that the Federal Reserve simply does not have through monetary policy. The effects of fiscal policy are also much more apparent in the short-term than monetary policy. In a time when everything is changing so rapidly and it seems like the economy is falling apart, we need fast action and faster results. The effectiveness of fiscal policy is also heightened when the economy is limited by the level of demand, which seems to be the case now during COVID-19, during which people are working less and saving more than ever.
But it is also important to note that while the potential effects of fiscal policy are promising, fiscal policy will not be as effective as it can if it is not aligned with monetary policy. Many of the negative effects of both monetary and fiscal policy can be negated when both are aligned, making for a more efficient expansion. While fiscal policy may seem more important as of right now, it is crucial that both policies work with each other. So, I turn to Fed Chair Powell’s comments on this in which he said that monetary policy has its role in the pandemic, but that fiscal policy is also critical. And with all the actions that the Fed has taken in the past months, easing the access to money for all, it could be beneficial to take a step back for now and allow the federal government to assist the economy. This lack of action by the Fed is in fact a calculated decision and may well be their best course of action at the moment.
