Selva Demiralp

Selva Demiralp is a professor of Economics at Koç University, Istanbul, teaching monetary policy and central banking. selvademiralp.com

Photo taken from the official website of the Fed.

The Federal Reserve has had another emergency meeting, the second within the last fortnight. On March 15, they cut the policy rate by 100 basis points and brought it to the zero-lower bound. In addition, they re-started large scale asset purchases which had ended in October 2014. They lowered the reserve requirements to support loan growth and lowered the primary credit rate by 150 basis points to encourage banks to borrow directly from the Federal Reserve.
These shocking decisions that were announced on a Sunday afternoon reflect serious concerns about an upcoming recession. In the face of its fast-diminishing artillery, the Federal Reserve decided to disarm most of its remaining weaponry at once in order to take control. Chair Jerome Powell noted that the global measures to protect people from the coronavirus Covid-19 pandemic will slow the American economy down, which will be particularly felt in the second quarter.

Financial stability first, economic growth next

Even though Powell noted that the American economy has its feet firmly on the ground and the labor market is stronger than ever, the outlook may not be as positive. Given the fact that the $3.5 trillion injection over the last decade is not quite drained from the system, a new wave of liquidity injections will push the financial system to unchartered territories.
The Fed’s decision has two dimensions: the first is to reduce financial strains in an environment of rapidly accelerating panic and uncertainty; the second is to stimulate growth. Recall that the Federal Reserve reduced the policy rate by 50 basis points on March 3 in an emergency decision. Yet the decision was not sufficient to contain the panic. On the contrary, financial stress and volatility increased in the days that followed.
At the first stage of the stress, the “safe haven” instincts dominated the markets and demand for US Treasuries increased rapidly. Bond prices increased and interest rates declined. At the second stage where uncertainty and confidence were further eroded, investors did not even perceive U.S. Treasuries to be safe enough and wanted to cash them out. This led to a decline in bond purchases and when everyone acted with the same instinct to dump the Treasuries, liquidity dried out in the Treasury market.

What happened between March 12 and March 15?

The Federal Reserve intervened again on March 12. They announced that they would purchase Treasury securities for up to $1.5 trillion through repo operations for a duration of up to three months. This time, the problem was the hesitant primary dealers, who are the Fed’s counterparty in these operations. Apparently, the dealers did not want to inflate their balance sheets with such large volumes of repo transactions due to regulatory disincentives. Instead, the Fed decided to purchase large volumes of these securities directly through outright purchases, to provide the much-needed liquidity.

Powell justified their actions with the need to ensure proper functioning of the US Treasury market, which is the foundation of global financial systems. If the interruptions in this market are not resolved quickly, the problem spreads to households and businesses in the form of financial constraints. Central banks need to provide liquidity at times of stress and fulfill their function as the lender of last resort.

Is it QE or not?

Following the 2007-2009 crisis, the Federal Reserve first lowered its policy rate to the zero-lower bound. Next, it engaged in large-scale asset purchases of long-term Treasuries. This way, it was able to lower long-term interest rates.

The large-scale asset purchases by the central bank to lower interest rates are known as quantitative easing (or QE). Not all security purchases are considered QE, however. QE is a non-conventional monetary policy instrument that is put into operation once the conventional policy rate is exhausted. The goal of QE is to stimulate the economy rather than market stability.

The Fed deliberately avoided using the term QE when it started asset purchases in September 2019. At that time, the policy rate was still positive and changes in the policy stance were signaled by changes in the funds rate, not through asset purchases. However, this “denial” by the Fed confused the markets which misinterpreted it as a commitment problem.

As of March 15, the policy rate is once again at the zero bound. The supplementary asset purchases of $700 billion are aimed at keeping long-term rates lower and stimulating the economy. Hence, these purchases are consistent with the definition of QE. Thus, from this point onwards, we will not hear from the Fed officials that what they are doing is not QE, which should please the markets.

What will the Turkish Central Bank do?

As the risks of a global recession are mounting, it is unavoidable for Turkey to experience a slowdown. The Central Bank of Republic of Turkey (CBRT) will want to stimulate the Turkish economy, just like its foreign counterparts. Nevertheless, the biggest challenge is that in an environment with an appetite for low risk, a rate cut might trigger an exchange-rate depreciation. This is particularly true in a country when the policy rate is already below the inflation rate. Thus, it is more appropriate to search for alternatives that will stimulate the economy other than the policy rate.

Had the CBRT not cut the policy rate so aggressively over the last eight months, it could have faced these difficult times on a stronger footing. Yet it is too late to look back and criticize the past. Looking forward, a cut in the required reserves ratio  along the lines that the Federal Reserve has implemented could be a proper decision that should encourage loan growth without changing the policy rate.
Banks need to keep a fraction of their deposits at the central bank to meet their reserve requirements. The reduction in the required reserves ratio allows the banks to use a larger proportion of their funding to extend loans. In countries like Turkey which are particularly vulnerable to capital movements, reserve requirements can be a useful macroprudential tool during times when it is difficult to change policy rates.

I think it would be appropriate for the CBRT to limit its accommodative policy to the change in reserve requirements, and not consider another rate cut at its policy meeting on March 19. The support for the economy should come from fiscal policy where possible and focus on the industries that are most heavily affected by the pandemic.