“The mission of the Federal Reserve System is to foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.”
For a nation as economically diverse as the United States, achieving this goal is no small feat. However, the FED has several tools at its disposal that have proven effective in restoring order to the capital markets.
The FED’s Toolbox
Early 2020 brought an economic black swan in the form of the novel coronavirus (COVID-19). Late February through March featured record crashes in global stock markets, extreme weakness in commodities, and all-time lows in U.S. Treasury yields. Not since the subprime debacle of 2008 had the world’s financial system been placed under such pressure.
Amid the COVID-19 panic, the FED turned to the lessons of 2008 to manage the crisis. The decade-old playbook featured a two-pronged approach to re-establishing pricing stability:
- Reduction of the Federal Funds Target Rate: Cutting interest rates is the primary tool used by the FED to jump-start economic activity. Typically, rates are reduced incrementally at scheduled meetings. Nevertheless, they may be adjusted anytime the FED sees fit. To battle the COVID-19 panic, interest rates were repeatedly cut to 0 percent throughout the first half of March 2020.
- Extensive quantitative easing (QE): QE is a catch-all term used to describe FED open market operations aimed at increasing the money supply. The goal of QE is to provide market liquidity via the direct purchase of various securities.
Hoping to replicate the success of 2008, the FED aggressively applied both of these devices in March 2020. Although the actions didn’t initially stabilize pricing volatility, they brought liquidity to the credit market and reassured lenders. As of this writing, the jury is still out on whether or not the FED’s QE and rate cuts effectively combated COVID-19 fallout.
What Can the FED Do If Traditional Policy Doesn’t Work?
When faced with unprecedented threats such as the COVID-19 pandemic, it stands to reason that the FED’s conventional weapons may not be effective. If a 0 percent Federal Funds Target Rate and trillions of dollars worth of QE fail to jump-start the economy, what is left to do?
Theoretically, not a whole lot. However, one of the benefits of the Federal Reserve Banking System is flexibility. To address unique problems, members of the Federal Open Market Committee (FOMC) work together to develop creative solutions. One such solution is the negative interest rate.
A policy of negative interest rates assigns a cost to individuals, businesses, and banks that deposit their funds in other banks. Under negative rates, savers are penalized for storing excess capital instead of investing or spending it. First enacted by the European Central Bank (ECB) during the crisis of 2008, this policy has gained popularity among developed economies. Practitioners include the European Union, Japan, Sweden, and Switzerland.
As of March 2020, the U.S. FED has never implemented a negative interest rate policy. According to FED Chairman Jerome Powell, negative rates are not the answer to the COVID-19 question. At a March 15 emergency press conference, Powell dismissed the idea:
“We do not see negative policy rates as likely to be an appropriate policy response here in the United States.”
As of this writing, there are no plans to implement negative interest rates to mitigate the impact of the COVID-19 pandemic. Nonetheless, these types of policies are not unheard of and may come to the U.S. at some point in the future.
Want to Learn More About the FED?
If you’re an active trader, then understanding the function of the U.S. Federal Reserve is a facet of trade that it’s best not to ignore. A great way to stay current on FED policy is to check out the weekly Daniels Trading futures market newsletter. Featuring insights and analysis on the pressing issues of the day, the newsletter is a valuable resource for anyone active in the markets.