Central bankers have played a vital role throughout the COVID crisis. With the global economy in the grip of its deepest-ever recession, the world’s central banks have had to inject huge amounts of liquidity into the financial system and government coffers to stop the health crisis turning into a financial catastrophe. The US Federal Reserve (Fed) has been the chief protagonist of the crisis response. It has massively expanded its asset purchase program, rolled out a number of emergency lending facilities and, most recently, has effectively committed to a ‘lower for longer’ policy on interest rates.
These huge liquidity injections have been one of the key factors in keeping the US economy and financial system rolling through the global economic shutdown. But recently, the pace of those injections has actually slowed somewhat. The Fed is still regularly pumping out substantial amounts of capital, but at a level closer to the ‘regular’ quantitative easing we saw over the last decade than the emergency levels we saw from March until the summer.
This is, to a certain extent, to be expected. Desperate measures should be reserved for desperate times and, with the US and global economies opening up, a steady return to normality is nothing to be afraid of. The Fed is still running multiple support initiatives, including its corporate lending facility, municipal liquidity facility and its Main Street Lending Program. As long as credit markets and the wider financial system are functioning properly, these measures combined with asset purchases should be sufficient backstops.
The crucial question, then, is how well are things really functioning? We can see from the relatively low (compared to past recessions) bankruptcy rates so far that the Fed’s priority – pumping-in liquidity to prevent mass default – has been reasonably successful. But for some of its other measures, it is not yet clear whether the mechanisms for getting capital to those requiring it are working properly. Take the Main Street Lending Program, for example. This is designed to help small and medium-sized businesses, including non-profit organisations, affected by the pandemic, and to support corporates that were unable to access other corporate support programmes (such as the Paycheck Protection Program). So far it has made $600 billion in loan facilities available to employers who were in good financial standing pre-pandemic and, while the loans are administered by private banks, the Fed promises to buy 95% of new or existing loans handed out.
Clearly, it is designed to encourage banks to get money to those who need it. And, though there have been some problems reported about unwilling lenders, which would also be in line with tightening lending conditions reported in the senior loan officer survey, we suspect most of the reluctance is on the demand side. In any case, the recorded take-up of these loans from businesses has been very low, with firms either unwilling or unable to access the funds.
This highlights a real problem for the Fed. In any crisis, when credit conditions tighten and the effective money supply gets constricted as businesses tighten their payment terms, a central bank can do its part to increase the supply of credit. But the actual demand for credit is beyond their control. Ultimately, even at generous rates and conditions, businesses will be uneasy about being saddled with more debt when the prospects for finding their feet are still so uncertain. Borrowing to stay afloat when you have no idea when or if the business will be viable again is not an attractive idea. The Fed can provide liquidity, but it is the economy that assures solvency.
Unlike some of the government’s fiscal measures, loans through Main Street – by their very nature – cannot be turned into grants or forgiven by lenders. As such, both the lender and the borrower have to assess the loan’s viability. Even though the bank’s liability for the loan is small, the fact it has any liability at all means it has to make a risk-based decision. That the loan must be paid back means the business has to assess whether it should take on more debt. With the threat of a second wave or increased lockdown still hanging over the economy, both of those things are extremely difficult to assess.
For the moment, the Fed seems to be hoping that demand for Main Street loans will naturally pick up. This is not an unreasonable expectation. We are already seeing a bounce-back in US economic activity. The fact that bankruptcies among smaller businesses have been relatively contained so far is a big positive. But there are complications. Along with the Fed’s liquidity provisions, the government’s fiscal measures have been crucial in preventing widespread defaults. However, most of these programs are either expired or expiring – with unemployment support currently being extended only through an executive order from President Trump. These direct support schemes are arguably more beneficial as they are not mediated by the banking system. Banks, by their nature, lend to make profit. But these emergency loans are currently primarily for survival, not for profit, and in times of financial trouble, risk-based decisions can be a hindrance to economic support. For Main Street loans to work effectively, and the banking system to be helpful in providing economic support, the prospect for making money needs to be there – and that has been the problem so far.
Now that summer is over and we are in the final quarter of the year, renewed efforts to resolve this credit impasse could prove crucial. Due to seasonal effects, Q3 is usually the lowest quarter for bankruptcies. As such, some analysts expect a spike in default rates towards the end of the year. To us, it is hard to say whether the lower take-up of loans recently is a sign of stability or not – given the demand issues mentioned above. However, if we do see a pick-up in loan demand from now until the end of the year, we would view this as a positive, as it would suggest businesses or individuals see the potential to make profits – the sign of a healthy economy. But it is likely that the Main Street Loan Program and other emergency lending schemes will need to be extended – by whoever is in the White House at the time. We have had the emergency intervention from the Fed, now we need to see that liquidity getting into the real economy.