4/30/20

You gotta hand it to the Fed.

Traditional monetary policy is pretty straight forward: The policy lever is the nation’s money supply, which the Fed can adjust through various mechanisms. The policy choice deals with the question of how much to open the spigot. That judgment requires striking the right balance between the dual goals of achieving high levels of employment and at the same time to keeping inflation in check. Too much money threatens inflation; too little threatens output and employment.

These days we’re clearly in the situation where the direction of the policy is unambiguous; and the Fed has taken unprecedented steps to dramatically expand the money supply. Unfortunately, one of the traditional mechanisms for expansionary policy to work its magic is compromised. We’re in what Keynes identified as “the liquidity trap.” In normal circumstances, increasing the money supply works to lower interest rates and subsequently stimulate investment (spending). In today’s environment, however, where interest rates have been at near record lows for months, that interest rate effect has been inconsequential.

While the expansion of the money supply gives banks greater capacity to make loans, finding credit worthy borrowers in this time is problematic. Under its Main Street Lending Program, the Fed appears to have figured out how to overcome this difficulty. The program is expected to generate a volume of $2.3 trillion in loans to businesses of all sizes, albeit with specific requirements and features.

The Fed won’t make the loans directly. Instead, it will depend on “eligible lenders” (U.S. insured depository institutions, U.S. bank holding companies, and U.S. savings and loan holding companies) to make the loans, but subsequently, the Fed would buy those loans from the originating institution. Key provisions are that the original lender must maintain ownership of 5 percent of the loans and that the Fed pays the originating bank an origination fee.

The requirement to maintain a portion of the loan on the bank’s balance sheet is to assure that the bank won’t turn a blind eye to credit risk considerations, enhancing the prospect of the loans being extended to credit worthy borrowers. Still, in today’s environment, even the best credit risks may still be problematic. The origination fees, however, will serve to mitigate this heightened uncertainty.

Genius.

Kawaller holds a Ph.D. in economics from Purdue University.