Money mischief: Fed’s response to COVID-19

At all levels, governments have taken extraordinary steps to slow the spread of COVID-19 and provide relief to those suffering from economic hardship. Many of these actions have been publicly discussed and debated. But not all. One overlooked agency is the US central bank, the Federal Reserve. The Fed’s new programs are unprecedented and deserve serious attention. All citizens who aspire to responsible public engagement must think hard about what the Fed is doing, and what it means for the country.

The Fed’s goals, according to its “dual mandate,” are maintaining maximum employment and stable prices. It accomplishes these goals by buying and selling assets, and occasionally making loans. Traditionally, monetary policy worked as follows. If the Fed was worried about an economic slowdown, it would purchase assets, such as government bonds, using newly created money. Those purchases expanded the quantity of reserves in the banking system. Then, as banks lent out the new money, overall economic activity would increase. The result would be falling unemployment and rising prices. If the Fed became worried about inflation, it would do the reverse: sell assets and eliminate the money it received from circulation, thereby putting the brakes on markets.

Following the 2007-8 financial crisis, this operating framework changed significantly. The Fed stopped focusing on the overall quantity of reserves, and instead managed inflation by adjusting the interest rate earned by banks that kept deposits at the Fed. One way to think about the Fed is as a “bankers’ bank.” If the Fed pays banks interest on reserves, it can prevent banks from loaning out newly created money. Also, as the crisis unfolded, the Fed paid less attention to market liquidity and more to the balance sheets of specific financial institutions. It increased loans to nonbank financial businesses. It propped up asset prices, such as mortgage-backed securities. And when the supply of bank reserves ballooned, the Fed prevented inflation by paying banks not to lend.

This brings us to the Fed’s COVID-19 response. The Fed revived many of its programs from the financial crisis, such as nontraditional asset purchases. But it’s also doing some truly novel things. These include direct loans to small-and medium-sized businesses, as well as to municipal and state governments. Taken collectively, these actions further push the Fed away from traditional monetary policy.

This is dangerous for two reasons. First, there’s no reason to think the Fed is particularly good at making loans. It’s not a profit-seeking entity, after all. (Whatever profits the Fed makes, it remits to the Treasury.) If the Fed loses money on its loans, taxpayers will be stuck holding the bag. Second, although many of the Fed’s new activities were authorized by Congress under the CARES Act, there are serious political risks to these activities. Simply put, the Fed is now engaged in fiscal policy, not monetary policy. And fiscal policy is Congress’s job. By passing the buck, Congress has expanded the Fed’s mandate to a worrying degree. Because the Fed is now directly allocating credit, Congress may try to increase its control over the Fed, using economic means to achieve political ends.

The darkest days of the COVID-19 crisis were perhaps not the right time to raise these concerns. Reducing the pain caused by the pandemic was the most important task. But now, we must deal with the consequences of what our representatives have done. And what they’ve done is, frankly, quite dangerous. The Fed should not be bailing out businesses and governments. And Congress should not be using the Fed to evade democratic oversight of its spending decisions.

We, the people, need to tell our politicians: enough is enough. The Fed should stick to monetary policy, leaving fiscal policy to the people’s representatives, in Congress assembled. If we don’t get control over this soon, we’ll be stuck with market instability and meager economic growth. That should be concerning to all Americans.

Alexander William Salter

Alexander William Salter is an assistant professor of economics in the Rawls College of Business at Texas Tech University, and the Comparative Economics Research Fellow at TTU’s Free Market Institute. He is also a Senior Fellow at the American Institute for Economic Research’s Sound Money Project. Website: awsalter.com. Twitter: @alexwsalter. Email: alexander.w.salter@ttu.edu.