This is different

Fed cuts rate to zero, what next?

A key role of any central bank is to provide liquidity to the financial systems. During times of economic distress liquidity dries up – value of assets falls, demand shrinks, and businesses find it difficult to manage everyday operations. Central banks add liquidity into the system through multiple ways. On Sunday, US Fed went the tried and tested way of buying Treasury bills worth US$ 500 bn. It also increased its holding of agency mortgage-backed securities by US$ 200 bn. In a different time, this would have been termed quantitative easing (QE) but the Fed was unusually reluctant to call it that. Separately, it also relaxed norms on capital and liquidity buffers that Banks are mandated to have. The need for these buffers is to prevent Banks from going bust in case there is a run on them. Fed is now asking banks to throw caution to wind temporarily and support households and businesses by extending as much credit to them.

The other role central banks have is to manage demand and inflation by acting on interest rates. The Fed by bringing interest rates down to zero has signalled to borrowers to go out and buy things. There’s no further elbow room for the Fed on interest rates (of course, you can have negative interest rates) and its future actions will be limited to increase liquidity in the system.

So, what happened next? The markets tanked on Monday (Dow fell by almost 3000 points). First, the markets viewed Fed’s moves as signs that things are worse than what they thought. Second, the news about Covid-19 got worse in the US and a drawn-out partial shutdown of economic activity looked the most likely case.

QE worked during the 2008-09 crisis. Why is it being viewed ineffective by the market in 2020? That’s because the current crisis is fundamentally different.

Why is this crisis different?

The different economic crises of the 20th century was caused by either a supply shock (Great Depression, the 1973 oil crisis) or demand shocks (World Wars, 9/11 etc). As financial systems became complex and sophisticated, financial system shocks started appearing as well (1987 Black Friday or 2008-09 Lehmann crisis). As mentioned in an earlier blog, we have both a supply and demand side shock with Covid-19. The global supply chain which is hugely interconnected is disrupted because of closure of factories (supply shock) and demand is falling as people stay at home and economic activity comes to a halt (demand shock).

All this has happened when we have the highest debt to GDP ratios in most big economies – US 108%, China 275%, UK 86% and France 98%. Corporate debts are at their historic highs in these countries. Clearly, a partial or near complete shutdown of countries for about a quarter (or more) is going to push many of these leveraged corporates into bankruptcy leading to job losses. A large number of loan defaults will make banks, who have a huge corporate loan book, shaky. Once banks start to show weakness, the contagion will spread, and we will have a financial shock as well.

In that sense, this crisis is unique in that it brings demand, supply and financial shocks together. Most central banks will continue to pump liquidity and find very little traction for their moves. Governments will start taking fiscal steps by preparing bailout packages for specific industries to help them tide over the lockdown period. In the absence of a clear view on how long the lockdown last, this will only go that far as a solution. You can keep giving bailouts but if people don’t go out and buy things, nothing will change. If bailouts don’t work, the crisis will engulf the financial sector and that will be that.

Conversely, if bail outs work, we will end up with countries saddled with ever higher debts and more vulnerable in future to any economic shock.

It is a no-win situation.

Meanwhile, China has expelled US journalists

China has decided to expel 13 journalists from 3 US media organizations in what it terms a retaliatory move. US had last month classified state owned Chines media organizations as diplomatic missions and brought them under tighter controls. The Trump administration believes many of these Chinese media agencies provide cover for spies operating on US soil.

We are in le Carré territory now. Cold war days are back.

China has been viewing the negative media coverage from US media outlets about its handling of Uighurs or the re-education camps in Xinjiang with suspicion. CPC likes to control any critical reporting about itself. The reportage on initial mishandling of Wuhan crisis was the last straw just as the Party was spreading the propaganda about how it handled the spread much better than the democratic west. Trump, deeply aware of his dwindling election prospects in light of stock market collapse and a likely recession, was looking for a scapegoat. His sudden pivot to call Covid-19 as a Chinese virus is a step in that direction. Expect worse name-calling from Trump on China as the election season gets underway.

So, apart from a trade war, we also have old-fashioned diplomatic squabbles and expulsions between the two biggest economies just when we need coordinated actions among all countries to contain the pandemic. Trump will continue to escalate while China won’t back down as it gets it economy back in order faster than others.

Trump should just hope China doesn’t come out with a universal vaccine for Covid-19 soon. Tough words are great till you have to start eating them   

1 thought on “This is different

  1. […] bonds and other mortgage backed securities till it is needed (‘no limits’). We spoke about it here. The second is the Fed prints money. Not literally the greenbacks these days. They will simply add […]

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