The Fed has developed enough new tools that there are almost no limits to how far it can tighten. Prior tightening cycles often led to financial instability that prompted sudden easing, but that was before the revolution of March 2020. At that time the Fed acted as lender of last resort to not just the typical financial sector entities, but also to real economy entities including municipals, corporations, and even small businesses. The emergency facilities were intended to transmit low rates to the real economy even when the financial system malfunctioned, but those facilities can also be used to transmit higher rates. An aggressive tightening will likely lead to cracks in financial markets before inflation is tamed. In that case, the Fed now has the tools to support the real economy and keep tightening until the last ounce of inflation is squeezed out. This post reviews the Fed’s tool kit, notes still it lacks one important tool, and suggests Fed tightening can be more aggressive than expected.
Two Mode Transmission
The Fed has gradually bypassed the “middleman” and assumed a lender of last resort role to a wide swath of the financial and real economy. Historically, the Fed provided emergency loans to commercial banks who then lent to everyone else. But that model became less effective with the growing importance of capital markets. Today, borrowers obtain financing from a wide range of non-bank lenders including investment funds and securities dealers. During the GFC the Fed recognized this reality and acted as lender of last resort to some of these non-bank lenders through an alphabet soup of special lending facilities. The non-bank lenders were then able to continue providing loans to end borrowers.
The Fed went one step further during the March 2020 panic and acted as lender of last resort not just to financial intermediaries, but also directly to end borrowers. It provided loans to the real economy, including corporations, state and local governments, and even to small businesses. The real economy was thus able to access financing despite financial instability and concerns over the health of financial intermediaries. The Fed essentially insulated the real economy from the costs of financial instability. As first noted by Steve Kelly on his excellent blog, the policy response to something inevitably “breaking” no longer has to be blunt tools like rate cuts and QE.
The one tool the Fed still lacks is greater control over the Treasury market, where cracks can impact entities outside the web of its facilities. Treasuries are stores of dollar liquidity and also benchmark global dollar rates, so Treasury market malfunctions deeply impact both the real and financial economy. Yet, Treasury yields are determined by many factors beyond the stance of monetary policy. The size of the fiscal deficit, market liquidity, regulatory constraints, foreign reserve strategies, market sentiment and many other factors shape these fulcrum rates. A crash in bond prices may lead to rates that are too high, and a massive flight to safety due to developments abroad may lead to rates that are too low.
A more refined tool beyond QE/QT would be needed for monetary policy to more effectively reach all corners of the dollar world. QE and QT are basically half measures intended to influence Treasury yields by buying or shedding set quantities of Treasuries. Policy implementation by targeting quantities was already experimented with in the 1980s with mixed success. Targeting rates proved to be more successful and is currently implemented in the front end through administered rates. A further extension of this in the footsteps of the BOJ may be needed at some point. Recall, malfunctions in the repo and FX swap markets led to Fed facilities that act as soft rate ceilings.
Pulling Out the Stops
The Fed’s has stated an “unconditional“ commitment to price stability, and largely has the tools to back that up. Future Fed lending facilities may or may not take previous forms, but the precedent of directly engaging the real economy has been set. This greatly expands the transmission of monetary policy, despite weak control over longer dated Treasury yields. The Fed’s single focus now is inflation, which is a real economy phenomenon that is likely less sensitive to higher rates than the financial economy. By essentially disintermediating the financial system, the Fed can address these two economies differently. Policy can be far tighter and remain so even after “something breaks.”