Key links in the physical supply chains are heavily concentrated in Asia. Trade finance—the “financial supply chain”—which underpins the production supply chains, is U.S. dollar‐denominated and supplied by banks in Japan, Korea, Taiwan, China and Hong Kong. But these Asian banks’ access to dollar funding is limited. When dollar‐funding stresses occur in Asian financial markets, they ricochet toward U.S. banks and finally to the Federal Reserve as the ultimate supplier of dollars or dealer of last resort.
These funding problems have already started to show up in the U.S. money markets. The term repo auction conducted by the New York Fed on March 5 was three times oversubscribed. Bids were $72.55 billion compared with the $20 billion offered. In other words, dealers are concerned that over the next two weeks they may need cash to meet demand from their correspondent banks in Asia or to ensure they can bid in the coming U.S. Treasury auctions.
How should the Fed respond? Last Tuesday the Federal Open Market Committee decided to cut the range for the fed‐funds rate by 50 basis points. The world’s major central bankers and commentators fetishize interest rates. They cheered the Fed’s move because they believe that changes to interest rates are an indicator of the central bank’s monetary‐policy stance. In times of trouble, they think, lower fed‐funds rates are countercyclical and therefore desirable. But now the central bankers think they are out of, or nearly out of, ammunition, since interest rates are near zero, or even negative. In an unexpected twist, central bankers have become the loudest proponents of fiscal stimuli.
The focus on interest rates originated with John Maynard Keynes and has been propagated by antimoney Keynesians ever since. Consider: During the Depression, the Fed’s discount rate was 6% when the stock market crashed in October 1929. By April 1931, it had plunged to 1.5%. This signaled to many that monetary policy had been loosened. But interest rates weren’t the only things plunging. So was the money supply, indicating that monetary policy was actually too tight. Interest rates as a gauge of the Fed’s monetary‐policy stance were—and are—no better than flying blind.
Monetary policy today has become detached from reality and the needs of markets. It is driven by misleading theories about what interest rates can achieve. Contrary to popular belief and the wisdom of crowds, monetary policy isn’t about interest rates. It is about providing the right amount of funding—the right quantity of money.
The right response to the current volatility is to follow Walter Bagehot’s classic dictum: Supply ample funds at a penalty rate against decent collateral. In other words, the Fed needs to supply liquidity to deal with the panic—whether by quantitative‐easing purchases of long bonds, by Treasury bill purchases, by repos or, most important, by increasing the amounts of U.S. dollar swaps available to the central banks of Japan, China, South Korea, Taiwan and Hong Kong.
If the Fed acts to remove the financial stresses in the market via liquidity injections, the panic will subside and a recession can be avoided. The injections can then easily be withdrawn so that they don’t later generate inflation.
Though the coronavirus pandemic poses serious short‐term problems, it need not exacerbate the financial panic or tip the global economy into a recession. But the right strategy is crucial. The Fed and other central banks must let go of their interest‐rate fetish. They must do what central banks have traditionally done to tamp down and extinguish panics. Ample liquidity—read: money—must be supplied at penalty rates.