Question

The impact of the Coronavirus has been devastating on the U.S. population and economy.   According to Mr. Jerome Powell, Chairman of the Federal Reserve, economic growth is likely to shrink 20-30% leading further increases in unemployment and bankruptcies – both personal and business. Focus on the financial and banking sectors.

How the short and medium term impacts are likely to be on equity and debt markets.

• As investors and borrowers of debt capital, what challenges are likely to present and how should these actors adjust in the changed environment?
• What are the likely short and medium term impacts on both community and large banks in terms of their asset values, credit risk evaluation and maintain their own equity capital?
• What are likely to be the response of regulators and the Federal Reserve to help balance and sustain the monetary sector to restore confidence and viability of businesses, banks and consumers alike?

Answer 1

In addition to the already high level of policy uncertainty, the effects of the coronavirus outbreak have a commonality with the 2008 financial crisis, specifically, its unknown magnitude. There are uncertainties about the scale of the virus, contagion rate, mortality rates, risk of incidence, and more. On top of the usual online disinformation and swirl of conspiracy theories, there are questions about the accuracy of the health statistics coming from China, in part because of China’s history of providing less-than-credible numbers related to its economy. Federal Reserve Chairman Jerome Powell remarked that it’s “very hard” to understand China’s economy. That issue of credibility has only become more challenging during this crisis and it makes assessing the impact of the virus on the global economy that much more difficult.

How may a heightened sense of uncertainty affect the economy? It could affect businesses, households, and financial market participants. Businesses may hold off on investments because they don’t know what happens to supply chains as well as their domestic and international customers. Internationally, it is not known where and how far the virus will spread. This makes it hard or even impossible to assess the effects on supply chain and demand disruptions discussed above. But if these effects are difficult to evaluate, businesses will not know whether they should continue with planned or even new investments. Yet, any slowdown of business investment in the United States would come after investment spending by U.S. firms has already fallen from March to December 2019.

Businesses are not the only ones that could pull back amid uncertainty. Households, worried about contracting the virus, could cut spending on some items such as traveling and going out. Moreover, this health risk poses a real economic risk, as many households have inadequate health insurance, which could leave them with large doctors’ bills when they get sick. And, most Americans do not have paid sick leave, meaning if they get sick from the virus and need to stay home, they will not get paid. In light of the risks, many people will view it as good economic precaution to avoid activities that increase exposure to others. On an economywide scale, though, this means less spending and thus less growth.

WHAT IS THE FED DOING TO SUPPORT THE U.S. ECONOMY AND FINANCIAL MARKETS?

Near-Zero Interest Rates

• Federal funds rate: The Fed has cut its target for the federal funds rate, the rate banks pay to borrow from each other overnight, by a total of 1.5 percentage points since March 3, bringing it down to a range of 0 percent to 0.25 percent. The federal funds rate is a benchmark for other short-term rates, and also affects longer-term rates, so this move is aimed at lowering the cost of borrowing on mortgages, auto loans, home equity loans, and other loans, but it will also reduce the interest income that savers get.

• Forward guidance: Using a tool honed during the Great Recession of 2007-2009, the Fed has offered forward guidance on the future path of its key interest rate, saying that rates will remain low “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” Such forward guidance on the overnight rate puts downward pressure on longer-term rates.

Supporting Financial Market Functioning

• Securities purchases (QE):The Fed has resumed purchasing massive amounts of securities, a key tool employed during the Great Recession, when the Fed bought trillions of long-term securities. Treasury and mortgage-backed securities markets have become dysfunctional since the outbreak of COVID-19, and the Fed’s actions aim to restore smooth market functioning so that credit can continue to flow. The Fed initially said it would buy at least $500 billion in Treasury securities and $200 billion in government-guaranteed mortgage-backed securities over “the coming months.” But, on March 23, it made the purchases open-ended. It also expanded purchases to include commercial mortgage-backed securities. And, it issued forward guidance to reassure markets that it will “purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.” Although the Fed is not calling it “quantitative easing” (QE), everyone else is calling it that.

• Lending to securities firms: Through the Primary Dealer Credit Facility (PDCF), a program revived from the global financial crisis, the Fed will offer low interest rate (currently 0.25 percent) loans up to 90 days to 24 large financial institutions known as primary dealers. The dealers will provide the Fed with equities and investment grade debt securities, including commercial paper and municipal bonds, as collateral. The goal is to keep the credit markets functioning at a time of stress when institutions and individuals are inclined to avoid risky assets and hoard cash, and dealers may encounter barriers to financing rising inventories of securities they may accumulate as they make markets. To re-establish the PDCF, the Fed had to obtain the approval of the Treasury Secretary to invoke emergency lending authority under Section 13(3) of the Federal Reserve Act for the first time since the crisis.

Banks and other financial institutions may restrict and reprice credit because they cannot properly assess short-term risks to particular borrowers, sectors, or countries. Less credit availability could make it harder for businesses, especially smaller ones, to invest and grow. And, some potential home buyers could find it harder to get a mortgage. Credit market uncertainty could then exacerbate the demand fallout from the coronavirus.

There is also an international wrinkle to growing uncertainty. International financial investors could become worried about the unknown risks to the global economy from the coronavirus. They could look for the comfort of a safe investment. Traditionally, U.S. treasuries are seen as very safe investment. However, more money coming into the United States from abroad typically strengthens the U.S. dollar, and a stronger U.S. dollar will eventually make U.S. exports costlier, making it more difficult for U.S. firms to compete globally.