Peter Conti-Brown – a legal scholar and financial historian at the University of Pennsylvania, as well as a Nonresident Fellow in Economic Studies at the Brookings Institution – returns to Macro Musings to discuss the new Fed-Treasury relationship that is emerging in the wake of the war against COVID-19. Peter and David breakdown the CARES Act, the aggressive and extensive policies recently taken by the Fed, and the implications for monetary policy moving forward.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Peter, welcome back to the show.
Peter Conti-Brown: It's always a pleasure to be here.
Beckworth: Great to have you back on. Now, how are you holding up in this lockdown of ours that we're facing?
Conti-Brown: Well, yesterday my three year old found a canister of hot chocolate, dumped it on the floor and started doing snow angels in it after he'd stripped down. It kind of sums up how it's going in the Conti-Brown household. We've had a lot of hot chocolate snow angels with the three year old.
Beckworth: Yes. So are you near Philadelphia?
Conti-Brown: Yep, I live just north of the city.
Beckworth: Okay. So do you have a more rural setting or urban setting? Are you able to get out in your yard? Get out, get fresh air or are you kind of confined to indoors?
Conti-Brown: Pretty confined. Ironically enough, we had a major construction project going on in our backyard, a large retaining wall that we were rebuilding and that kind of stopped halfway through. So our yard is a construction site, so we've been pretty cooped up. We can still go through walks in our neighborhoods, it's quite lovely.
Beckworth: Oh good. Well I'm here in Nashville, Tennessee, a more rural part of Nashville, kind of the outskirts. So I've been blessed in terms of being able to go outside, get fresh air, step in the yard, so it's been nice. I know listeners of the show have often emailed me and ask, how do you do it? How do you commute to DC from Nashville? And it's true, I'm up there two weeks a month. I'm at home two weeks and this is where the commute is finally paid off because if I were living in DC, I too would be holed up with three kids in the house, but instead I'm a little more relaxed condition. And in fact I think Nashville, we can call it now the home base for this podcast for the foreseeable future until things change, when we get back up to DC.
Beckworth: But I'm excited to have you on Peter because there has been a lot happening. And you were recently on the show. We discussed your paper, “Restoring the Promise of Federal Reserve Governance,” it was a great paper. So listeners, if you haven't seen it or heard the show, go back and check it out. And Peter, I'm curious if you've got any feedback on that paper.
Conti-Brown: I've heard from a lot of people, academics and folks on the Hill, folks in the Fed. Some people felt that I was a little bit too hard on the Federal Reserve banks. One small part of the paper was about transparency in the appointment process and re-appointment of Federal Reserve presidents. But even in their critiques there, my rejoinder was, well, what you just mentioned is all the pathologies of opacity. They thought that I wasn't fair to some of the people in it and they asked me to get in contact and get the real story. And I said, "Well, no, no, no. You don't understand. I don't want the real story as told in the gossip circles, I want to see what the public gets to see." And there that transparency issue is very profound.
Conti-Brown: I think that there's no evidence that my concerns about Fed governance are playing a role in this crisis though, so I want to be clear about that. I don't want to be the carpenter with a hammer who sees everything as a nail. It looks like the FOMC is moving in lock step, even with President Mester’s dissent on the monetary policy move, these muscular extensions of Fed emergency authority have been unanimous among the FOMC members. So the Fed governance process I think is not at the front and center of this process. So once the crisis is over, I'll start beating that drum for more transparency and Fed governance again.
Beckworth: Fair enough. But it is interesting how unanimous the FOMC has been except for that one president in terms of passing all these measures really quickly, swiftly. And I say that in comparison to 2008, 2009. There was a lot more discussion, division, Bernanke really had a big challenge to get everyone on board to support the programs during that time. So it's been a very different speed and commitment and drive at the Fed this time around.
Beckworth: So Peter, before we get into the main topic of today's show, I hear you have a new book on bank supervision in the United States called “The Bankers Thumb.” Tell us about that briefly.
The Banker's Thumb, Peter's Co-authored Forthcoming Book
Conti-Brown: My co-author, Sean Veneta and I are both historians and we wanted to look, there's so much written about regulation and legislation books about Glass-Steagall or Dodd-Frank and regulation that the Fed might issue, but there's not a lot of academic research on what we regard as a much more powerful frontier in the financial system, which is supervision, which is a highly discretionary set of practices whereby supervisors at the Federal Reserve, FDIC, comptroller, state supervisors, and others shape bank behavior, and banks in turn shape supervisory behavior. So we take a grand tour of supervision starting in the post-Civil War, right up through what is happening right now or what's happening right before the coronavirus, which was a major initiative at the Federal Reserve from Vice Chairman Randal Quarles to emphasize supervision and even to regularize it, to make it look a little bit more like regulation which has real costs and benefits to it.
Conti-Brown: So that book, we're hoping to finish it up in the next couple of months, and then off it goes to our publisher at Harvard University Press.
Beckworth: And we will have you back on the show to discuss it. So let's get into today's topic, and that is this whirlwind of activity that's transpired over the past few weeks at the Federal Reserve in response to the COVID-19 virus. So just a quick summary of these and we'll come back and discuss these in more detail later. But this is just some of them, unlimited QE, including now commercial mortgage backed securities. They have a primary dealer credit facility, expended Repo operations, increased discount window lending, money market and mutual fund facility, commercial paper facility. They're indirectly supporting municipal markets and some of those facilities. They got TALF which is going to support consumer credit. They have two corporate bond facilities, main street business lending facility, extended swap lines, and now a new repo facility for foreign central banks. There's just a lot going on and a lot of this transpired really quickly.
Beckworth: And the speed of these changes is breathtaking, again compared to what happened in 2008, 2009, how quickly they got put into place. But along with this speed has come some concerns that maybe things were done that crossed some lines, maybe blur the lines between monetary policy, fiscal policy, maybe crossed some legal lines. And I had a previous guest on this show, Jim Bianco who says, "Look, this is great here and now, but on the other side we're going to have some of those challenges trying to separate the Fed from Treasury going forward." This may be a case where we have to have a new accord, kind of like we did in 1951 when they really think hard about how we're going to do that.
Beckworth: And you've made similar comments and you have a nice new explainer on a part of this issue that's out at Brookings Institute on their website and it's an explainer on the new Fed-Treasury emergency funds. So this kind of focuses in on the CARES Act and some specific language and a new legislation that's going to affect the relationship between the Fed and the Treasury in a way that's never been seen before. So why don't we begin with that explainer and tell us what did Congress do that you're covering in this piece?
The CARES Act of 2020
Conti-Brown: Congress created something that we've never seen before in the United States, in the history of the relationship between the Fed and Treasury and the Fed and Congress, and that is of the $2.2 Trillion that were appropriated for coronavirus relief, 500 billion were to the Treasury, and this is in section 4003 of the Bill. $46 billion is for the Treasury to oversee for sectorial relief. This is for airlines, for cargo, air carriers, national security, but $454 billion, not trivial money, is appropriated to one part of the government for the exclusive purpose of investing in another part of the government, this is, these are Treasury funds that can only be used as loans, loan guarantees or investments in Fed programs or facilities.
Congress created something that we've never seen before in the United States, in the history of the relationship between the Fed and Treasury and the Fed and Congress
Conti-Brown: Now, the penultimate version of this legislation did not imagine something so closely tethered to the Fed’s initiatives. Roughly $450 billion had been for the Treasury to invest in support of Fed emergency actions. So that would have had given the Treasury a lot more autonomy. They could have gone their own direction so long as they were supporting generally market activity. This was criticized as a slush fund, a Treasury slush funds with poor accountability.
Conti-Brown: And so the Senate responded, some might say overreacted by saying, "Okay, we're going to remove virtually all discretion and only allow the Treasury to invest in Fed facilities. We've never seen this before. The only time we've seen it before is literally now, right before the passage of the legislation, there've been two instances of the Treasury using the exchange stabilization fund to invest in some of these Fed’s facilities, commercial paper and money market mutual funds. And to be clear, this looks nothing like what Treasury and Fed did with AIG and some of the 2008 mechanisms. In 2008 what we had is the Fed cracking the glass on its emergency lending authority in a much more bespoke and idiosyncratic fashion, in March, 2008 to support JP Morgan's purchase of Bear Stearns and the fall of 2008 to support AIG and to support for a very limited time, Lehman's US-based broker dealer before Lehman went bankrupt.
Conti-Brown: And then came TARP and then came by and large the Fed's more broad based market oriented facilities. Now here we're just seeing the bespoke interventions are all illegal now and the Fed starts from the proposition of market liquidity and is now moving even further out into direct bilateral loans to corporations and now announced Main Street, perhaps state and local financing as well. And so the folks at the Fed, Treasury and especially Congress felt that it was appropriate then to get the Treasury to have skin in the game but still to have the Fed drive these policies and have treasuries the deputy.
Beckworth: Were there any strings attached to Treasury or the Fed in using these funds?
Conti-Brown: So there are, there are strings attached to that sector lending I mentioned to airlines, those are quite extensive. Here the strings are for their prohibitions on stock buybacks and dividends. There are restrictions on expectations about payroll retention. There's no real sense that the Treasury has discretion to waive those conditions, and indeed, the secretary can add restrictions to that sectoral lending. But again that's only $46 billion of the whole 500. For the rest, the conditions are pretty narrow and they are waivable. Any programs that the Treasury invest in will have a prohibition against stock buybacks and dividends, but only to the extent that they are these direct loans rather than investments in broad-based facilities. So think if you want to go and borrow money from the Federal Reserve directly, they're going to be strings attached unless the Treasury waives them. Those strings are going to be about what you can do with the money in terms of dividends and the like.
Conti-Brown: But if you're participating in one of these broad based facilities where your counterparty is not the Federal Reserve, but you're just simply getting liquidity by pledging and collateral, then those strings are not going to be attached. This is really up to the Fed to determine what conditions are.
Beckworth: The question is, was this necessary? Legally did the Fed need this extra capital or is it just more political cover way to say, "Look, we're all in this together and there's some oversight involved."
Conti-Brown: I think that's the $5 trillion question quite literally. We heard Jay Powell on his interview on, was it the Today Show or Good Morning America, where he basically implied that the Fed cannot take credit risk or cannot lose money in its lending. But that's not legally true at all. And indeed these emergency lending authorities are about exposure to credit risk. It's about injecting loans, primarily loans and unaccepted collateral that can, and in crisis often will go bad. So that's not true and there's no part of the law even after the CARES Act passage that requires Treasury equity in order to support Fed lending. So this is not a legal requirement and I really hope the Fed does not start to insist that it is. The Fed sometimes plays fast and loose with its 13(3) restrictions, but this is not one of them.
Conti-Brown: Now, there is a restriction in 13(3) that says that the Fed can only lend when the lending is endorsed or otherwise secured to the satisfaction of the Federal Reserve banks. And that underwriting process is required by statute. They have to assign a lendable value to the collateral accepted. But that says nothing about the level of collateral that's needed, and it certainly says nothing about Treasury's participation there. So I think that your question has the answer that this is about political cover. It's about making the Secretary of the Treasury the face of some of these lending programs. We want the Fed with the Treasury support to lean in on this crisis. That means being quick, being nimble and deploying these loans to a lot of different people, that means there will be losses. And when there are losses, we want the Treasury Secretary to say, "Yeah I approved this program," Treasury money was at play as well, but that's purely for political cover. It's not needed economically and it's not needed legally.
Beckworth: And I would add to that economically the Treasury already backstops the Fed. So this is kind of just putting some dressing on the window to say, "Look, hey we're here, we're being explicit about it." But if the Fed had gone ahead with these programs, and let's say it had taken a loss on its balance sheet, well, who would bail it out? It'd be the Treasury. So implicitly it's already there. So this has been interesting to see it unfold. My question to you though about this would be, what are the implications long run? Do you see any problems this might bring about in the future?
Conti-Brown: I agree with Jim Bianco that this is a watershed moment for Fed-Treasury, and I'd add Fed-Congress relations. Fed-Treasury relations, because there it is not difficult to imagine treasury's involvement in crisis lending bleeding over into things that are much more about a monetary policy lever, such as how to unwind an eight or 10-trillion-dollar balance sheet, whether or not to lift off the zero lower bound and when. And if part of that is going to be unwinding these emergency facilities that perhaps prove to be extremely popular, what happens when Treasury and the President say, "We want to keep the spigot running on Main Street lending, even though we've got a vaccine. We've got the cure. There's no more social distancing, but this is really popular and we've got a mid-term election coming up," and the Fed says, "We're no longer comfortable with this"? What happens then?
This is a watershed moment for Fed-Treasury, and I'd add Fed-Congress relations
Conti-Brown: Well, the law clearly gives the first priority to the Fed, but I don't know ... Well, a lot will depend on how the Fed and Treasury structure this relationship going forward. So I think this is a watershed moment for Fed-Treasury relations, because they are engaged in a kind of fiscal policy. An emergency lending policy touches on both fiscal and monetary policy to a very important degree.
Beckworth: Let me play devil's advocate here like I did with Jim. You're a historian so you can appreciate this, but during war times this happens quite often, right? During war times, you kind of see the consolidated view of government finance. You don't see this separate Fed, the separate Treasury. World War II, World War I ... I mean, they all came together to a fight a war, and the challenge is kind of pulling them back apart after the war is over. So we have the famous Fed Accord 1951, which took some effort and wasn't an easy process. So maybe it's reasonable to expect something like this to happen in such a severe crisis, which many have called a war, a war against a virus.
Conti-Brown: I mean, I don't even think that's devil's advocate. I think it's fair. My critique about what comes next is not a critique about whether this should have occurred. I get why the Fed would have lobbied for Treasury participation. It's not to allow them, as they've sometimes characterized it this week, to reload their balance sheet. That's totally irrelevant. But it does allow them the freedom of movement so that they can be more aggressive than they'd otherwise be, because they can count on the Treasury getting their back in wartime scenarios.
Conti-Brown: And of course, I could take you all down the rabbit hole of Fed history. The Fed- Treasury Accord of 1951 is only one of many different kinds of informal agreements between the Fed and Treasury around wartime about how to liberate themselves from a far too accommodative posture. After World War I, World War II, the Vietnam War, around a little bit the Gulf War. So I think it's very appropriate for us to expect some sort of exit strategy. But what I would say, what history tells us, is we have no idea how to anticipate the length of this entanglement and what its consequences will be.
Conti-Brown: My biggest concern right now is not an inflationary concern, but it's simply a logistical one. How do you unwind a 10-trillion-dollar balance sheet? And that's where we're headed. I mean, we're going to come out of the coronavirus scenario with a balance sheet that probably is 2+x the size of the balance sheet that went into it.
My biggest concern right now is not an inflationary concern, but it's simply a logistical one. How do you unwind a 10-trillion-dollar balance sheet?
Beckworth: Yep. That's right. I've seen estimates that big, which would put us at about 40% of GDP, which is about the size of the ECB's balance sheet currently. They're growing too.
Beckworth: I wonder then, kind of stepping back and looking at this problem that reemerges every time there's a serious war or crisis, is there a place to have some kind of mechanism or rule in place so that when you do get into a war or something like that, there's certain guard rails that tell you, "Okay, now's the time when you can closely work together because it's important, but when certain conditions are met, we will take these steps to pull us apart"? Some kind of steps, guidelines to make it easier for the transition back to a more normal arrangement.
Conti-Brown: Well, the CARES Act has a sunset clause in it. Not for these facilities, mind you, but for the duration of some of these loans, at five years. That seems to me to be a pretty appropriate window. But these are largely guidelines, and the Treasury Secretary retains a huge amount of discretion, as does the Fed Chair and the FOMC, or the Board of Governors, I should say, in designing these facilities. So right now we don't have any kind of automatic stabilizer for Fed- Treasury relations. No kind of rule-based system that will trigger a default posture.
Conti-Brown: What I hope to see then there is very robust Congressional oversight of this system. I think that's going to be more important than ever. Earlier I said that this is a watershed, not just for Fed- Treasury relations but also Fed-Congressional relations. As everyone who watches the Fed closely knows, there are two truths about Fed in Congress. The first is that Congress has willed the Fed into existence and can will it out. The second is that the Fed is a formidable lobbying force on Capitol Hill. So Congress is the boss, but the Fed is not indifferent to its own fate. So this means that Congressional oversight has got to be very searching, even a little uncomfortable for the Fed and for Treasury, because this can't become an equilibrium point, right?
Conti-Brown: Beyond a crisis equilibrium. We've got to have it be that the kinds of Congressional oversight and the people who do it have enough of an institutional perspective that they're willing to fight not on behalf of Republicans or Democrats on this party priority or that one, but an institutional perspective that says, "Congress is the boss. We're not about to abolish the Federal Reserve. That conversation can remain on the fringe. But we will not be steamrolled by arguments or claims that this existing set of arrangements has to continue in this way forever."
Beckworth: Okay. Well, this will be a conversation I'm sure we will revisit on the show many times, and we'll have you back on maybe in a few months to see where we stand. And hopefully we do get through this crisis relatively quickly. We don't know for sure, but by the end of the year hopefully we would see some kind of improvement, maybe by mid-year, and we can have another conversation about the emerging relationship between the Fed and the Treasury and how necessary it will be to have a new accord or vigorous Congressional oversight to make sure that the old relationships are restored.
Beckworth: Well, let's move on and talk about some of the many actions the Fed has taken over the past few weeks in order to fight COVID-19. They've been just a lot of very bold, leaning-into-the-crisis type behavior. And again, as you mentioned earlier, much more aggressive early on than they were in 2008, 2009. I think part of that is they've learned. They're more agreed on what the problem is, and that consensus has made them bold and aggressive.
Beckworth: So let's walk through a list of actions they have done, and I'm going to draw upon a paper to help guide our conversation here. It's from your colleagues at Brookings, and the title, we'll link to this in the show notes, is, "What's the Fed Doing in Response to the COVID-19 Crisis? What more could it do?" It's by Jeffrey Cheng, David Skidmore, and David Wessel. It's a really great piece. Summarizes everything the Fed has done up until this point. Some of the items are more benign; some are more controversial, some of the newer ones, and we'll get into those. But let's just list everything the Fed has done to date.
Beckworth: The easiest one is the Fed has cut rates to 0%, or 0 to 0.25%. That's fairly straightforward. I don't think there's any controversy there. Maybe the only thing left would be, why not go negative? Why not head down that path? I'm wondering, Peter ... We have talked about this before. Do you think the Fed is legally able to go down into negative territory if they think it's warranted?
Should the Fed Go Negative?
Conti-Brown: I do think that there is room in the Federal Reserve Act to accomplish this task. The question will be what specific mechanism they propose, and that's going to trigger different parts of the Federal Reserve Act. My co-author and friends, David Wishnick and Miles Kimball, are collaborating on a paper, I think for Mercatus, actually.
Beckworth: That's right.
Conti-Brown: Going through the legal architecture of a negative interest rate. It's non-trivial. So my short answer is yes, I think it is legal, but it's non-trivial to get the technical details right and understand exactly how they would accomplish this. Would they accomplish it through master accounts which all financial institutions use through the Federal Reserve system? Would they accomplish this through the primary dealers? What's the coercive mechanism that allows them to combat capital flight? There are a lot of different questions that have to be resolved for this.
Conti-Brown: I think that the Fed's lawyers and the central bankers there are extremely eager to pull other levers besides negative interest rates, but ... Which, many happy returns, if that's the way that the world permits them to go. But as you and I have discussed before, and I know we see this in very similar ways, if the state of the world has driven interest rates deeply into negative territory, the Fed's indifference to that reality is going to be a very tight money policy.
Conti-Brown: So they've got to figure out a way to get creative, to follow money where it is and allow for that kind of flexibility. Otherwise that's going to be the same errors that they committed in the Great Depression.
Beckworth: Peter, I hope people really take that lesson to heart. The Fed is following where the fundamentals lead them. Because this was the big issue in 2008, 2009, and we saw rates drop almost before the Fed moved in this crisis. In fact, I think one-month, three-month Treasury bill rates have traded negative for the past few weeks or some part of that time. And the Fed still has its policy rate at 0 to 0.25%. But I hope this crisis, if anything, teaches many observers that the Fed is more of a follower than a setter of the underlying interest rates in the economy. But we'll have to wait and see for that.
Quantitative Easing and Purchases of Commercial MBS
Beckworth: Alright. Next big thing they've done is they've restarted QE, and they're doing it now with an unlimited amount, so they haven't ... Initially, they did set a number, but now they are just open-ended. And they've added another innovation. That is, they're going to buy commercial mortgage-backed securities as well. Any problems there?
Conti-Brown: I'm telling you that I hate the term quantitative easing.
Conti-Brown: I hate it. It's ubiquitous. I don't hate you for using it-
Beckworth: Oh, I know.
Conti-Brown: You're using it in the way that people will recognize it. Everybody calls it QE. The Fed formally calls it large-scale asset purchases, LSAP. You know what I want to call it from now on?
Conti-Brown: Our Section 4 facilities. Or sorry, Section 14 facilities. We're talking 13(3) facilities, but these are Section 14 facilities. Section 14 of the Federal Reserve Act governs open-market operations. What they're doing is in crisis times announcing a very different approach to their open-market operation authority, and that authority is here not limited. It's not to support their federal funds rate. It's to support other kinds of priorities, which is in this case flattening the yield curve and providing massive liquidity to these market segments.
Conti-Brown: But that is an emergency action. It should be of some kind of non-infinite duration, and so I ... No-one's going to follow me on this, but the terminology I would love for the Fed to use would be Section 14 facilities, because it emphasizes that the Fed has a variety of emergency lending and operational options, and this is just one of them.
The terminology I would love for the Fed to use would be Section 14 facilities, because it emphasizes that the Fed has a variety of emergency lending and operational options, and this is just one of them.
Conti-Brown: The problem that I see with the conversations around QE is it's so anchoring, and it makes people think, well, what do you do if you hit the zero lower bound? Oh, you go engage in QE. Well, that's just one thing among many things that you need to do, and these facilities are permitted by the Federal Reserve Act in Section 14, but they shouldn't be overemphasized. And I'm glad to see, frankly, that the Fed didn't sit back on its heels and say, "We're going to do large-scale asset purchases. Everybody's going to call it QE, and that's going to reassure the entire marketplace." It seemed like they were poised to do it, and that lasted about 72 hours and then they realized that it wasn't enough.
Beckworth: Yeah. I think an additional point to bring up in light of what you've just said is that QE is often confusing for people when they try to distinguish between temporary repo operations and then large-scale asset purchases used to support the economy. The distinction between those two is hard to see if you're not following closely and you know the details in-depth, so I think it is a great point that maybe the naming of this action should be different. Maybe, Peter, they'll follow your suggestion and call it Section 14 activities.
Conti-Brown: I like that. The repo market ... That might be the next thing you wanted to talk about.
Beckworth: Yeah, actually, let's go this. The repo market activity is expanded. I mean, the Fed's doing everything it can to keep Treasury markets and repo market activity fluid. There were some problems there. Any comments on that activity?
Increased Repo Market Activity
Conti-Brown: I'll tell you, I've been skeptical for many years of my very good friend Morgan Ricks' money view of the 2008 crisis. Not that I think that he's wrong about the runnability of certain kinds of assets, but I'm less convinced of kind of a comprehensive solution that's focused almost exclusively on maturity mismatch and the like.
Conti-Brown: But I'll tell you, the roiling of the repo market, starting in September, have made if not quite a believer, much less of a skeptic of me about a money view of the financial system. It's hard to justify that much just staggering liquidity that's needed by the central bank to support what should simply be a funding operation for private firms. The fact that they've had to ... What are the numbers at right now? A trillion dollars?
Conti-Brown: Yeah. It's just amazing. What were they at in July of 2019?
Beckworth: I don't remember. I can't ... I don't recall.
Conti-Brown: Tens of billions, I would guess.
Beckworth: Yeah. But it's going to be a trillion dollars, plus two more installments of 500 billion if they need it going forward.
Beckworth: So it's a lot.
Conti-Brown: So Morgan's view would be that they, broker-dealers and others without a bank charter need to fund themselves through the capital markets with lending maturities of longer than a year. I think it's something that we need to take very, very seriously, to think about ... But I hope when the dust settles on COVID-19 and we're all back high-fiving again, or at least giving each other knuckles or whatever we're going to do in the next iteration of society ... I hope we take a very serious look at the fragilities of the repo markets. I think that the justification for having the Fed cheek-by-jowl with basic funding needs that should exist in the CFO's office of these institutions ... Very hard to justify in light of that fragility.
Beckworth: So Peter, the answer is that before the crisis turmoil hit, the Fed was offering 100 billion in overnight repo, 200 billion in two-week repo. And it's now offering one trillion in daily overnight repo, 500 billion in one month, and 500 billion in three-month repo. So it has gone up dramatically.
Conti-Brown: And those 100 and 200 billion numbers are since the fall. I mean, we should be clear, well ahead of the novel Coronavirus even in China, there was something wrong with the repo markets and we saw some wild swinging. Some people were saying they had to do with regulatory requirements that were settling all at a time or end of quarter requirements that were tripling down. But there's something fishy about repo market operations if it required such emergency liquidity interjections on the order of $75 billion was the first intervention I think in September.
Beckworth: Well, I can just sense that George Selgin is listening right now, raising his hand out there and saying, I know the answer. It's the operating system in addition to the regulatory issues and the perfect storm of tax payments coming in and all those things. He would tell us to go look at their operating system. But that's for another show. So let's move on to list of things the Fed has done. So the Fed has also extended lending to securities firms, so to the primary dealer credit facility. What about that facility?
The Fed's New Lending Facilities
Conti-Brown: The Primary Dealer Act is the governing charter for the interactions that the Fed has with primary dealers, has extensive authority to determine who can be a primary dealer. I think there are about 24, 28 primary dealers designated today. I don't remember the exact number, but there the idea is that these are institutions that have been vetted. They have very large, numbering in the tens if not hundreds of thousands or more of counterparties. And so, the idea is funding for lending essentially.
Conti-Brown: So getting it out there so that people can cover, use their broker dealers without any questions that a broker dealer is going to go down and so they can execute their trades and nobody has to worry about flight from these accounts. There's not going to be a domino effect from having broker dealers under duress. So this is the Fed on a very strong basis. This was the first invocation of 13(3), the glass is broken. Secretary of the Treasury signs off. This strikes me as, under the circumstances of the world as we have it, that this is an appropriate first move for the Fed for its emergency authority.
Beckworth: All right Peter, what about the money market mutual fund facility? The Fed is once again stepping into that market.
Conti-Brown: Two important points here. I guess maybe three. The first is, why are we even here? Money markets are an arbitrage, they're legal arbitrage. You want to get a little bit more basis for what is a substitute for a bank account or a checking account but outside of a bank charter system. And so that I think, folks like Morgan Ricks and many others have a really strong critique of that institutional framework. This is a resurrection as was the primary dealer credit facility of 2008 emergency facility. There are two things that are new about this. Number one is that this is the first instance of having the Treasury invest in a Fed facility. Treasury ponied up $10 billion. And the second is it was probably illegal for them to do so.
Conti-Brown: They used the exchange stabilization fund. And after that, after 2008, Congress made explicit the fact that it is illegal to use ESF, the guarantee money markets. Now, their argument might be this is not a guarantee, it's an investment in. But functionally it's a guarantee for sure. And indeed they're self aware enough that I think they inserted a ratification of this action in the CARES Act. I should check that.
Beckworth: Okay. So it passes muster in terms of legal.
Conti-Brown: So it passes muster. And in any event, the creation of the $454 billion fund is to move the Fed out of these ESF for future investments.
Beckworth: Okay. So these two we just talked about, the money market, the liquidity facility as well as the primary dealer facility, we've seen them before and we may have questions about why we still have to use them, but they're here. So nothing really new except for the areas you've touched on. All right, so another action the Fed has taken, it has encouraged the use of the discount windows. Peter there's been a big stigma surrounding that, but they got eight big banks to agree to borrow from the discount window. So, thoughts on that development.
Conti-Brown: Here I am going to... I'm thinking a very idiosyncratic view and I want to recognize that for our listeners. But I would like for emergency lending all to be of limited duration, and to have an exclamation point and an underline over the fact that these are emergency interventions. I think section 10B, which is the discount window, is another opportunity for the Fed to get experimental but on an emergency basis. Historically section 10B and the discount window is about emergency lending to the idiosyncratic risk of well-capitalized banks.
Conti-Brown: They can't fund themselves in the federal funds market, they're not able to fund themselves with using LIBOR or whatever else and so they go to the Fed. And there is a stigma attached to this because the question is, why can't they fund themselves elsewhere? But again, if the mantra is that the central bank should be providing funding for lending, which is a Bank of England phrase, then we should want to see dramatic uptake of discount window lending not to save the banks but for the banks to save their clients.
Conti-Brown: I think this is... we just saw Treasury announce today that it's going to use the banks for small business administration loans and pay the banks fees in order to basically give these forgivable loans out. And I think the Fed should set up 10B facilities just as they've already set up section 14 facilities and a lot of 13(3) facilities. I'd like to see 10B facilities that are for the specific provision of specific kinds of client-focused loans. Not just to fill gaps in bank funding, but to provide a kind of facility that might be, for example, something I've been talking with my dear friend and co-author David Skeel about, is better in possession financing and bankruptcies.
Conti-Brown: Fed could absolutely do that through 10B or it could set up, the original purpose for a lot of this would be agricultural funding. No prohibition on that. So attaching conditionality to some of the 10B loans would of course remove the stigma because this isn't about the banks, and it would also be some sort of way to turn the discount window into an instrument to reach main street more effectively without skipping the banks entirely.
Beckworth: So you'd have the discount window open to more counterparties?
Conti-Brown: No, not necessarily. No, I would make sure that you still had to be a member bank. You still had to be supervised by the Fed. That's still appropriate. Keep the counterparties limited. What I mean is, the traditional theory of discount window lending is these are loans that the banks need to meet their own funding requirements. What I think the discount window should be used in an emergency to do is that the Fed should fund these loans to lend to downstream clients.
Conti-Brown: The farmer or the dentist or the hardware store owner doesn't come and get money through the discount window that's appropriate for 13(3). Instead, they go to their bank and they say, "We need cheap funding where we don't have to pay back interest or principal for six months because there's an epidemic." The banks today would say, "We have no ability to do that." But if a 10B facility were open to that end, then the bank would say, "Yeah, no problem. We'll present that collateral to the Fed and we'll be able to fund this at 100%."
Beckworth: So this would be like the loans going from the SBA through the local banks, except these loans wouldn't be forgiven. The Fed can't forgive loans, right?
Conti-Brown: Right. I take a very creative lawyer’s approach to the Federal Reserve.
Beckworth: Okay. Maybe they could.
Conti-Brown: There's no prohibition on loan forgiveness. It is definitely in violation of the spirit of the discount window section to have loan forgiveness. But they get to set the interest rate wherever they want it. Right now the discount window is set at 25 basis points. And so, I think getting virtually a free 0% loan that they can pay back immediately, that does not create the same problems that a more onerous terms might present to help get out of a place where their income stream is completely shut down.
Beckworth: Okay. Well very interesting suggestion for the discount window. Let's move on to the more controversial programs and in particular I'm thinking about the new corporate credit facility, so there's the primary market corporate credit facilities and the secondary market corporate credit facilities, which allows it to buy secondary market investment-grade bonds as well as ETFs. What are your thoughts on that? Is this legal or is this illegal or is it somewhere in between?
Conti-Brown: Well, I think it's plainly legal. I know that some people don't like the idea of the use of Special Purpose Vehicles in emergency lending. It seems like it dodges the broad based participation requirement of 13(3). And for those of our listeners who are not as well versed in that statute as you and I are, after 2008 Dodd-Frank completely overhauled the emergency lending provisions of the Federal Reserve Act to make it so that participants in these programs or facilities, there has to be broad based eligibility for those participants.
Conti-Brown: But I think arguments that this is illegal... so when the Fed creates a facility, they're creating a legal entity that is incorporated under state law and we call that a Special Purpose Vehicle. Maiden Lane I, II, and III, those were SPVs from 2008. So it seems like, wait, the Fed just created some counterparty. There's only one of them. How is that broad base eligibility? That's a misreading of the statute. I think the statute, it makes clear that it separates participants in programs. Those have to have broad-based eligibility, the programs have to have broad-based eligibility for participants, but the programs and facilities can be idiosyncratic or bespoke. They can have a bilateral relationship with the Federal Reserve Bank. So there's no legal question about this.
Conti-Brown: The direct lending program is new. I'm not aware besides AIG and some of the Bear Stearn's maneuvers of this happening in 2008. But again, there's no legal question about it. The SPV facility model was the dominant model then and now, but it's not the only one that the Federal Reserve Act envisions.
Beckworth: Okay. Well, let me phrase the question this way. Why has the Fed waited until now to lend to corporations directly this way?
Conti-Brown: They don't want to be loan officers. They don't want to be underwriters. They do not want to step in front of the banks. The Federal Reserve sees itself in non-crisis times as just absolutely out of reach from individuals, besides member banks, asking for loans. They want the private sector to provide that intermediation. In non-crisis emergencies, the discount windows for banks are in distress. And then in real emergencies, you crack the glass on 13(3). But even then, the Fed wants to see itself providing backend market liquidity.
Conti-Brown: And here that's not enough for reasons that I think are pretty defensible. It's not the only path they could have traveled, but it's a defensible one. They've decided they did not want to wait for Congress to take over and create their own programs. They want to do a belt and suspenders approach with the SBA and the CARES Act and provide this kind of relief elsewhere too. So they are on their front foot here. They're getting creative. But I'm very skeptical of arguments that this is violating legality because they've opted in one hand for SPVs, on the other hand for bilateral loans. I'll state that these bilateral loans do come with greater conditions though under the CARES Act if the Treasury invest in those facilities.
Beckworth: Okay. Yeah, this is a 13(3) facility. They're using that part of the Federal Reserve Act to do it. And I think many people, what they think is, well, where in the Federal Reserve Act does it say you can lend to corporations directly or buy their bonds? I think the thing to understand is this is a 13(3) facility. It's temporary. It's not permanent. They won't be doing this on a permanent basis. At some point this will end.
Conti-Brown: My answer as to -
Beckworth: Go ahead.
Conti-Brown: Where on the Federal Reserve Act, is 13(3), and it's right there. It's any individual partnership corporation or business can be a participant in a program or facility with broad-based eligibility. Congress wrote that rule.
Beckworth: One thorny issue in lending to the corporations is currently they specified that it has to be investment grade corporate bonds, right? What if some of those bonds get downgraded and they're no longer investment grades. They're hoarding bonds that were once investment grade and now they're not because as the economy tanks, so might their credit standing.
Conti-Brown: There I think there's some incredibly live issue and it touches on another issue that the Fed has to grapple with right now, which is, the kinds of collateral that normally would have to satisfy them in other kinds of emergencies that are not so doom and gloom as the COVID crisis, that that standard has to change. And that's a descriptive point that I'm making. That's exactly what happened in 2008. The kinds of collateral that they were insisting on in the summer of 2008, different by the end of the year in 2008. It was different again in 2009.
Conti-Brown: And so, it's appropriate for them to make those kinds of adjustments. There is no requirement of the Federal Reserve Act that the collateral has to be investment grade. That was an announcement for this facility. I think they should change it. I think that they should have different kinds of metrics that are easy to implement. They also have a rule that they created that I think is a terrible mistake, which is that no entity that participates in 13(3) facilities can have failed to pay its undisputed debts as they come due 90 days before participating.
Conti-Brown: So, if you look at Cheesecake Factory that just said they're not going to pay rent right now, they can't participate in a 13(3) facility unless the Fed changes that rule. And in all fairness to the Fed, I mean, this is really hard to get right. Congress said you can't lend to insolvent entities using 13(3). But it doesn't define insolvent as anything other than bankrupt entities. And so, the Fed needs to get creative. It should immediately rescind that rule which they can do. And then they should get a little bit more creative about what kind of collateral they're willing to accept and recognize that that's going to be a sliding scale. They're going to take losses. They'll be exposed to credit risk. And that's okay. Nobody expects otherwise from them.
Beckworth: Okay. One other part of reaching out to the corporate sector is the commercial paper funding facility. We've seen this before. Any thoughts on that?
Conti-Brown: Not really.
Conti-Brown: I think this is more... This is-
Beckworth: Fairly standard. Yeah. Alright. The other big innovation that we haven't seen a lot of details on yet is the Main Street Business Lending Program that Federal Reserve has said it will do, but do we know anything about it yet? Any way to make sense of it?
Conti-Brown: I mean, not unless you've got something I do not have.
Beckworth: I do not. No, I do not.
Conti-Brown: As of today, I looked this morning. There's no specifications.
Conti-Brown: This is a facility that is a really weird part of the CARES Act, is this entire section. It's a longest section of a subsection of 4003, this 454 billion section, and they say the Secretary of the Treasury will endeavor to try to create a Main Street facility. What does that mean? "Endeavor to try." When my kids say, "I'm going to endeavor to try to finish my homework," I snap my fingers at them and say, "You will not endeavor to try."
Conti-Brown: "You will just do your homework." Right? I think the idea there is that the Fed is in charge of these facilities, and the Secretary is supposed to be helpful to them. Here's what I would expect. I will expect heavy conditionality on these loans, and the conditionality I expect would be around personnel maintenance, payroll maintenance.
Beckworth: Okay. Yeah. And this is the Main Street Business Lending Program. So small businesses, you think that come to mind. Also on Main Street, but not really part of the program, but in the same spirit, at least, I think is the Term Asset Back Securities Loan Facility, which will support consumer credit. So credit cards, student loans, auto loans. So that's also a facility we've seen before. So probably nothing there we need to spend much time on.
Beckworth: Okay, let's go to municipal borrowing. So the Fed is actually buying up some municipal bonds, and its money market liquidity facility and the commercial paper facility as collateral. But there's been proposals. In fact, we've had in our show, several guests, Skanda Amarnath and Yakov Feygin who've proposed as part of their Employ America agenda to have the Fed create a facility similar to the commercial paper facility that would buy municipal bonds. And they make the case, look, it's a part of the Federal Reserve Act already. They would also would go on and say it was a part of the historical assets that the Fed would purchase in the past. They went away from it to Treasury, and it's time to come full circle and go back to municipal bonds. What are your thoughts on that proposal?
Conti-Brown: It seemed pretty edgy and outrageous when they first made it, and now it seems like if tomorrow they announced a state and local, a state and muni facility, who would be surprised by that, right?
Beckworth: Fair point.
Conti-Brown: I mean, they've already announced that they're going to accept that as collateral for some of the corporate lending or others, so if you purchased this debt on the open market and they present it with the collateral, you'd be able to get very attractive loans from the Fed. I think that they've got a really strong legal basis. They haven't specified their proposal in much detail. This is a Section 14 proposal, too. Section 14 seems to limit this to revenue bonds, not general obligation bonds, but I could imagine a legal argument that looks and creates something different there.
Conti-Brown: We just have atrophy here. I looked today. We haven't seen municipal warrants on the Fed's balance sheet since 1934. So, I am not quite sure. I mean, we don't have a lot of experience with this, so in best at times, it would seem imprudent to move back into that world. These are very far from best of times. State and local governments are going to be under significant financial and fiscal pressure, so it seems completely appropriate for the Fed to move in this direction. I hope that it's not a 13(3) facility, though. I hope it's a Section 14 facility. I think it allows them some more flexibility there to provide some support.
Conti-Brown: I imagine it won't be. I think it'll probably be a 13(3) facility. I imagine there'll be co-investments from the Treasury, and I think it's appropriate. It's appropriate, if dangerous in terms of monetizing public debt. If that's your main concern, then of course then this is the Central Bank buying governmental debt from a different level of government. But I expect that we are going to see that, and it's going to be some really interesting experience for the Fed and for the states alike.
Beckworth: Okay, fair enough. Let's move on to the last part. There's a few programs we've left out for the sake of time, but the last programs I want to focus on are the international ones. So the Fed has had currency swap lines or dollar swap lines with a number of countries already. Remember, central banks, they expanded the list quite a bit, and they've also just introduced a standing repo facility where foreign central banks can deposit their treasuries there, and then get dollars. So they've effectively closed a lot of holes where central banks didn't have the dollar swap lines. So a large part of the world now has access to dollars via other central banks. Thoughts?
Conti-Brown: I read an entire article with David Zaring on this called “The Foreign Affairs of the Federal Reserve.” I'll send you a link to the article.
Beckworth: Yeah, I'll put it in the show notes.
Conti-Brown: The legal basis for the swaps is a little bit fast and loose. It's certainly one of those instances where they have not been authorized to do this. This is the fourth time they've engaged in swaps in history. 2008 was not the first, and the macroeconomic effect for having a reserve currency, which, I mean, the exorbitant privilege is the expression. The U.S. enjoys from having the reserve currency. It's pretty important, but there where there's power comes responsibility, and it seems being the banker of last resort to the world is a role that the Fed is taking very, very seriously. I'd be interested in your thoughts on the standing repo that was just announced. It seems to me that this is just an effort to make dollars available to those of our friends and foes alike who otherwise wouldn't qualify for the swap.
Conti-Brown: Is that right?
Beckworth: Oh, it is. For example, China was the big missing country or economy that didn't have a dollar swap line to the Fed.
Conti-Brown: I think the brick countries besides India as well.
Beckworth: Right, right. And the argument against giving China a dollar swap line is, look, they got plenty of reserves. They don't need it. And the other argument, the probably more political one, it would be toxic to give them these dollar swap lines to put their risk on the Fed's balance sheet. But I think it's important, because to offer them this repo facility, because in times of stress, they may not be able to sell their treasuries very easily. And this is an easy, certain way to get dollar funding to meet their dollar obligations.
Beckworth: And you're right. The dollar is this important currency around the world. We benefit from it. We also... There's a certain burden it creates for us. It tends to lead to more trade deficits, and we tend to have to bear that cost. But there's been a huge, huge blessing to humanity throughout the world because of the dollar. The dollar has facilitated globalization. Think of all the people lifted out of poverty. In my view, at least, I think it's a net win for the world that the dollar does play this role, but we have to be responsible stewards out that dollar role. And I think what the Fed is doing is important. So I fully support the extension of these facilities internationally, even if politically they might be a little more controversial.
Conti-Brown: And I'm going to channel my inner David Beckworth, too, that this is the provision of a massive amount of safe assets for the rest of the world.
Beckworth: That's right. That's absolutely right. In fact, I had a previous guest on a show who mentioned that the Fed should have done this a long time ago, and it would have decreased demand for our treasuries, knowing that these facilities are there and therefore it would have created potentially less trade deficits for the U.S. and all the problems that creates for jobs back home. But yeah, I mean, this is a big deal, and I'm happy to see it, and I'm interested to see what happens after it's all said and done.
Beckworth: So what will happen to these facilities? No, many of them will go away. The 13(3) facilities will go away when things do get better. But the extended number of countries who have a currency swap line and now this new repo facility that's called the Foreign and International Monetary Authority Facility or FIMA. I think it should stick around. I think the Fed should keep these facilities in place just because it will play a role in, again, edging or taking off that demand for safe assets in normal times, not just in stress times.
Beckworth: We're nearing the end of the show. In the time I have left, I want to kind of pull back and make an observation that, Peter, you can weigh in if you want to or you can pass on it. But the observation I want to make is that it seems to me interest rates are going to be stuck near zero for a long, long time for a number of reasons.
Near-Zero Rates for the Foreseeable Future: Implications for Monetary Policy
Beckworth: Probably the most obvious one is a super heightened level of risk aversion. People are going to race to buy treasuries ,and it's true, we're going to provide a whole lot more debt. So maybe that may offset that, but we've never seen a crisis like this. So I suspect the amount of risk aversion, the heightened risk aversion is going to be greater than the amount of debt we supply. But there's other things that play as well.
Beckworth: There's an interesting paper by Oscar Jorda, Sanjay Singh, and Alan Taylor, where they look at pandemics. It's a long historical look at pandemics, and they find typically after pandemics, when the labor supply declines, it tends to lead to a lower real interest rate. And the technical story is labor supply declines, the marginal product of capital declines and therefore your equilibrium rate decline. So if their story holds up, their findings hold up in this particular crisis, then that would be another reason why rates would stay low in addition to heightened risk aversion.
Beckworth: So a third reason I think rates will stay low, Peter, is an argument made by Nicholas Bloom where he makes the case that Total Factor Productivity is going to decline because of this crisis, not just the decline in the labor supply, but total factor productivity. And here's the argument he makes. He says, look, we are no longer engaged in face-to-face meetings, we don't have access to labs and equipment. Research and development is going to take a hit. And what this means is there's going to be a decline in intangible capital and R&D and just patents. And this is going to be really bad for TFP for a few years, which is going to drive down the growth rate of Total Factor Productivity, and that also should lead to lower interest rates.
Beckworth: So for all these reasons, I worry that rates will be stuck at zero, maybe even mildly negative for some time. That being the case, what will be monetary policy in the future? If the Fed no longer has rates to cut, we're going to go from a form of monetary policy where we're used to where the Fed cuts rates, whether it's short-term rates, or it's long-term rates on the yield curve. If all these rates get compressed, and they already are pretty compressed, I mean, the Fed is going to be forced to work through quantities, changing the monetary base, buying these assets we've talked about, and I'm wondering if this is going to lead to a fundamental rethink of how monetary policy is done in the future.
Conti-Brown: I mean, except the premises, I think we would absolutely have to see it. The Phillips curve was hanging by the thinnest of threads even before the coronavirus crisis. I'm surprised you didn't mention Paul Schmelzing in your-
Beckworth: Yep. There's another reason. That's right. He's on the show, too.
Conti-Brown: Yeah. Your recitation of factors that are pointing toward a very strong sense interest rates remain low. Obviously, I've got a mug that I'm looking at right now on my desk that tells me what the regime should be, which is NGDP level targeting. But the Fed, my expectation has always been post-2009 that we are going to continue to see economies with strong institutions but that are relatively small – places like Australia or New Zealand or Canada – experiment with monetary regime change. Bank of Canada is a really good example of this, of course. And so I would expect that within five years or less from now if interest rates are stuck at the zero lower bound, that we will see a lot more experimentation. And when you have a critical mass of experimenters that have proved to have superior institutional... Here, I mean monetary institutional frameworks, the Fed will follow, and the Fed will either follow on its own accord, or it's going to follow because Congress forces them to do so. But this is one of the reasons why I've been so consistently opposed to a Taylor Rule-like approach to the Federal Reserve Act, a legislative amendment forcing it, is that we want to stay nimble right now.
I would expect that within five years or less from now if interest rates are stuck at the zero lower bound, that we will see a lot more experimentation
Conti-Brown: Because we are in a world of unprecedented monetary turmoil, and the worst thing we could do is open up the Federal Reserve Act, graphed onto it a rule policy that will be wrong from day one, but then we're stuck with it for two generations because it's now in the legislation.
Beckworth: That's a great point. If we're stuck at zero or negative rates, the Taylor Rule won't be very useful in terms of the operations of monetary policy.
Beckworth: Yeah. Great point. Yeah, I think we're going to see, again with rates stuck at the effective lower bound or at zero that the Fed's going to rely more and more on quantities. You know, how much monetary base to create, how to get it out, what assets to buy, and in some ways this takes us back to more of a monetarist world where you're looking at quantities over prices, but it will be interesting to see how it all unfolds going forward.
Beckworth: Peter, we are out of time. It's been a great conversation. Thank you again for coming on the show.
Conti-Brown: It's such a pleasure, David. I can talk about this stuff for hours.
Beckworth: I know. Stay safe.
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