The April 12, 2020, posting on the Money, Banking and Financial Markets site, entitled “The Fed Goes to War: Part 3,” expands on the discussion of the extraordinary measures taken recently by the Federal Reserve. You can read the posting and learn more about this superb site and its authors here: https://www.moneyandbanking.com/commentary/. Let me offer a personal endorsement: I find the site consistently and exceptionally helpful.
Much has already been written about about this expansion of the Fed’s arsenal and the list of new facilities. Essentially, the playbook for last decade’s Great Financial Crisis has been reopened, and a whole new set of tools has been added. It is likely that this process will continue for months, until the COVID-19 response includes an effective vaccine in mass distribution. We recommend that readers examine the details of the Fed’s programs, since each of them will have some direct impact on your investments, asset allocations, business operations, and financial wellbeing or lack of same.
We also recommend that serious readers review the working papers recommended in the article, including those by Humpage (https://ideas.repec.org/p/fip/fedcwp/1402.html) and Carlson and Wheelock (https://ideas.repec.org/p/fip/fedlwp/2014-013.html). We agree with the authors about the value of learning the history of the Fed leading up to and including the WW2 period and the subsequent negotiation of the Treasury-Fed Accord of 1951. We expect that history to be revisited and updated after the COVID-19 crisis starts to recede into history.
Between now and then we expect that the Fed’s balance sheet will reach levels heretofore unpredicted and difficult to imagine. We also expect the federal deficit to reach multitrillion-dollar levels and for the massively enlarged federal financing program to continue for at least two years.
To understand the Federal Reserve’s role during the WW2 era, we recommend that serious readers review two books. The first is A History of the Federal Reserve, Volume 1: 1913–1951, by the late Allan Meltzer (https://www.press.uchicago.edu/ucp/books/book/chicago/H/bo3634061.html). Readers are advised to pay particular attention to Chapter 7, entitled “Under Treasury Control, 1942 to 1951.”
The second book is the monumental treatise entitled A Monetary History of the United States, 1867–1960, co-authored by the late Milton Friedman and the late Anna Jacobson Schwartz (https://press.princeton.edu/books/paperback/9780691003542/a-monetary-history-of-the-united-states-1867-1960). We advise readers to immediately read Chapter 10, which discusses the World War 2 period and the Federal Reserve’s policy actions as the United States vastly expanded its deficits and prosecuted the Second World War.
Let me just make a few points with regard to what I believe will be the outline of the COVID-19 fiscal and monetary policy response for the next several years.
1. The United States will run huge deficits that will rival or exceed previous wartime financing records. Fortunately, the country has the capacity to finance these deficits during this crisis and the recovery phase.
2. The Federal Reserve will create and apply as many financing tools as possible to facilitate financing of the national deficit and to maintain the liquidity needed for the operation of financial markets. The Fed realizes that this is the time for unrestrained policy initiatives and that the Fed is the vehicle needed to finance the country through this crisis.
3. As during the WW2 period, the Federal Reserve finds itself as the facilitating financing arm of the US Treasury. We can set aside the discussions of Fed independence and of “moral hazard.” Those must be saved for the period after this COVID-19 challenge has been met.
4. After the crisis it will take years for the Fed and Treasury to stabilize and unwind. Recall that WW2 ended in 1945 and that the Fed didn’t start to unwind for another three years and then only slowly. Not until the 1951 Accord was reached did the Fed and Treasury launch the operating procedures that lasted until 2008–9 and that now have been effectively repealed by events beyond any monetary authority’s power to control.
5. For those who haven’t studied monetary history, the name Marriner Eccles may not be familiar, even though the Fed building in Washington is named for him. Readers may want to study this man and the construction of the Fed he chaired preceding and during WW2. Present Fed Chairman Jay Powell now finds himself in the position that Eccles faced. Both men chaired an institution with the power to expand money and credit. Both have proven themselves patriotic Americans. Both have demonstrated the capability to rise to the occasion when the nation is under attack from an adversary.
One final note about interest rates. During the World War 2 period, the Federal Reserve set the short-term interest rate using the 90-day Treasury bill as the reference. The Fed set a “rigid” bid that maintained that yield at 3/8 of 1% and kept it there for over four years. The Fed engaged in whatever amounts of transactions were necessary to maintain that yield. Once the Fed “anchored” the short-term policy rate, it then intervened in a nonrigid but clearly intended pattern to manage the rest of the yield curve. Those rates were 7/8 of 1% for 1-year notes, 0.9% for 13-month notes, 1.5% for 4½-year notes, and 2.5% for the longest-term bonds (those had a 25-year maturity with a call feature at 20 years).
The Friedman-Schwartz treatise, referenced above, argues that only the short-term rate was purely “rigid.” The authors argue that the other rates were set by an “effective pattern.” The choice of a defining term for this policy is not important. What should be noted is that the Federal Reserve designed and maintained the shape of an upward-sloping yield curve. The computation of “forward rates” was effective then, and the Treasury market functioned throughout the war period, even as the deficit ramped up to over 100% of the nation’s GDP.
We expect the Powell Fed to find its modern version of this Eccles Fed structure. Therefore, we expect little volatility in the yield curve of federally guaranteed bills, notes, and bonds.
Stabilizing the “riskless” US Treasury yield curve is important, since it is the spreads of non-riskless instruments that reveal how market agents see the default risk attached to each type of instrument and to each economic sector related to that instrument. The Fed must watch those spreads closely, since their purpose is to minimize defaults that originate with the COVID-19 shock while still allowing market forces to establish pricing of risk.
In sum, we again confront a deeply challenging chapter of history in the making. We again are testing the leadership qualities of those placed in positions of grave responsibility by forces they never contemplated. That is the case at many levels of government and in every country around the globe.
Sir Winston Churchill carefully titled the second volume of his six-volume treatise about World War 2. He used the words Their Finest Hour to describe his country’s facing possible defeat, the glory of supreme resistance, and the eventual triumph. That example is now apt for the central bank of the United States. We are now watching the history of the Fed’s finest hour unfold.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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