The Fed: Avoiding a Depression

The U.S. economy will enter a recession this year, but the Federal Reserve’s 23 March announcement that it will buy an unlimited amount of Treasury and mortgage-backed securities (MBS) and introduce numerous facilities aimed at stabilizing the financial system may help avoid longer-term damage and accelerate economic recovery.

The Fed’s immediate goal is to keep credit flowing to the real economy.

In recent weeks, the sheer size of the risk aversion and flight-to-cash exhibited by investors has overwhelmed financial markets and the securities dealers and banks that are charged with intermediating markets and distributing capital throughout the financial system. Unprecedented volatility in Treasury and mortgage-backed securities (MBS) markets – which are supposed to be the safest asset markets – exacerbated this flight to cash, and propagated large price dislocations in other sectors of the bond market, including credit and structured product markets.

Regulatory- and pandemic-related operational constraints for financial institutions with access to conventional Fed lending, (e.g., through the discount window and term repo operations) hindered their ability to use the Fed’s short-term loans to stabilize markets. As a result, the Fed had to think of new ways to more directly support credit markets, corporations, and small businesses.

Fed goes all in

On Monday, the Fed announced unprecedented actions which did just that. In addition to taking a page from its 2008 financial crisis playbook, by announcing an open-end program to buy Treasury and MBS securities, it announced various new facilities to deal with this unique economic shock. Unlike the 2008 financial crisis, which hit banks and financial institutions, the non-financial corporate sector is the epicenter of this crisis. And to direct more targeted support to these sectors, the Fed announced it will create new Special Purpose Vehicles (SPVs), which will provide medium-term loans directly to corporations, buy existing high quality corporate debt securities in secondary markets, and make loans against asset-backed securities (ABS) held by a broader range of investors than just banks and broker-dealers.

These measures add to other programs introduced last week that will further support short-term corporate lending through commercial paper issuance and ensure that prime money market funds, which traditionally invest in short-term corporate debt, have ample direct access to liquidity in the event of redemptions. All told, the size of the Federal Reserve’s balance sheet has already surpassed the $4.5 trillion maximum level reached after the 2008 financial crisis, and we think it could well surpass $6 trillion before all is said and done.