A joke doing the rounds has it that on confronting an alien invasion, the first thing the US would do is cut interest rates. The gag is only moderately unfair: an absence of political leadership, and the White House’s undermining of American bureaucracy, have left the Federal Reserve as the first defence in the face of economic crisis. This may help in the short term. But socialising risk on the balance sheet of the central bank stores up problems for the future.
The scale of measures partly reflects lessons learned during the 2008 crisis. Moves to stabilise the financial system that took months to be instigated then were launched much more rapidly in response to the economic disruption caused by coronavirus. Swap lines with foreign central banks were introduced almost immediately, quantitative easing programmes were restarted and the Federal Reserve has intervened directly in money markets and corporate financing to take the burden off banks in a time of stress.
In total, these policies will extend the reach of the central bank much further into the US economy than ever before. Analysts at Bank of America forecast that the Fed’s balance sheet will reach $9tn by the end of the year, or about 40 per cent of US national income. Proportionally, that will bring the Fed roughly in line with the European Central Bank, though still far below the Bank of Japan, whose assets amount to more than 100 per cent of national income.
Purchases of corporate credit and commercial paper likewise move the Fed into new territory. Central banks in Europe and Japan have similar schemes, but the US has the largest corporate credit market; it also has a much greater commitment — rhetorically at least — to free market capitalism.
Overall, these crisis-fighting measures are welcome. The extraordinary monetary stabilisation measures appear to have halted the purely financial aspects of the crisis, stabilising money markets and easing the dollar funding squeeze: the S&P 500, the main US equity index, has rallied 9 per cent so far this month. An index of the dollar against other currencies has now eased from its highs.
Yet as Fed chairman Jay Powell said when he first cut interest rates, just over a month ago, this cannot “reduce the rate of infection or fix a broken supply chain”. Central banks can halt the financial contagion, but any long-term solution to the public health crisis will involve measures to mitigate the danger from the virus. In contrast to the rest of US bureaucracy — the president has shifted power between different departments, ensuring loyalists are in charge — the Fed has been unshackled.
There will be long-term negative effects. Investors were already complaining that monetary policy was distorting financial markets; many laid the blame for the plethora of now-controversial stock buybacks at the Fed’s door. Whether that is true or not, the best economic response is to get the virus under control quickly. Low interest rates cannot compensate for poor political leadership. The Fed would have less to do if health policy and fiscal policy did more.
For now, the only viable alternative to the Fed’s support for corporate finance is to let swaths of American business fail. That would probably mean at least a temporary cessation of the world’s largest credit market and a reshaping of the US financial system: unthinkable in the middle of a public health emergency. A financial crisis, a world war, a pandemic — like an alien invasion — require the normal rules of capitalism to be suspended. The challenge will be for the Federal Reserve to return them to normal when it is safe to do so. That may take a while.