In response to the Covid-19 health crisis, the Federal Reserve has taken a number of policy actions to help steady both the US economy and global dollar liquidity. On 12 May, James Bullard, president and chief executive officer of the Federal Reserve Bank of St Louis, joined David Marsh, chairman of OMFIF, to discuss the Federal Reserve’s policies, an outlook for the US economy, and global consequences of the pandemic.

Listen to the recording, or read the transcript below.

David Marsh: This is your 30th anniversary year, I believe, since you have been a St Louis man and boy. You took over as the president of the Federal Reserve Bank of St Louis and a member of the Federal Open Market Committee in April 2008, making you the second person with the longest tenure on the FOMC. Do you think the Fed, based on all the experience that you had there over the last 12 years, was well prepared for this pandemic? I did read again former Fed Chair Janet Yellen’s speech from October 2017, when she very carefully laid out more or less what you’ve done now. Clearly you’ve done it more extravagantly. Were you well prepared?

James Bullard: I do think it prepared us well having gone through the 2007-09 financial crisis, when it took a long time to get the same steps made during that period, because it was all brand new. Here, I think there was a lot of agreement that this was a major shock. There was a lot of agreement that you definitely wanted to handle the pandemic, but handle it in a way that did not create a financial crisis. The relatively quick response was to go to the 13(3)-type programmes and provide liquidity to financial markets. So far, I think that has worked quite well. There were problems with market functioning in March and maybe into April, but most of those have corrected. You could argue about it. As far as the initial way, the response has been much faster than it was in the previous crisis. That has served us very well in terms of market liquidity preventing this from morphing into a financial crisis, at least so far. The initial response has been quite good.

DM: We’ll come on to the macro questions in a moment. But if you just look at the way that the different desks were set up in March, and you said you reacted better or more quickly than maybe in 2007-09. Did the New York Fed have all the operational equipment, so to speak? These extraordinary measures that they’ve taken in areas, all the commercial credit, all the commercial paper, was that laid down in advance, or did they more or less make that up on the night? Clearly the Treasury function of the mortgage securities and so on, you might have that already in your playbook? Did this innovative approach get dreamt up very quickly, or was there some sort of rehearsal sheet for all that?

JB: Most of this is about making sure that markets are functioning, making sure you have price discovery, making sure that you have active trading in various markets. And if you don’t, we know that the freezing up of markets, the sense that you can’t train an asset at any price under any circumstances, that’s what causes a crisis atmosphere and makes people really panic. So to the extent we’ve been able to be a backstop in a lot of markets, I think that’s what has really helped us in the initial phases of this pandemic crisis. It’s so far so good, and interestingly from an economics point of view, some of the effects occurred without the programme actually being set up. It was the announcement that the programme would be set up that calmed markets, and some of those are just coming online today or in the near future here.

DM: The Fed didn’t have to buy a single security. You just announced that. I think only overnight as it started.

JB: From a market point of view, it showed that the central bank was concerned about market functioning, concerned about these issues, and wanted to make sure that we had price discovery and active trading in markets that might otherwise be threatened.

DM: We’ve seen a lot of international coordination as well from the central banks. Less so regarding politics in general, but central banking co-operation seems to be functioning pretty well internationally. These extensions of the swap lines, for example, happened relatively quickly. We all know the Fed is the central bank for the US, not for the world, but in some ways you’ve been very quick to capitalise on and live up to the international expectations that different parts of the world do place in you. Was that also all predetermined, would you say, or was that a sudden burst of blood to the head that made the Fed suddenly much more international?

JB: We learned from 2007-09 that the swap lines are quite important. Obviously, it’s an international dollar funding issue, but we had standing swap lines with a number of major central banks around the world. The question was always, to what extent do you want to extend these swap line arrangements to other central banks, and we’ve come upon a good solution to that. We did extend to other central banks, but then in addition to that we created a facility where foreign entities can come directly to the New York Fed and swap out their Treasury securities for dollars. And this is a way to get dollar funding in other parts of the world where it’s needed, so that calmed markets quite a bit again.

But I would emphasise, this is a financial crisis, and it’s really not centred on Wall Street or London or financial markets around the world. This is definitely a health crisis. From an economics perspective, it’s an exogenous type of shock, and the goal here is to make this not morph into a financial crisis and make things much worse than they would otherwise be. And so far, we’re doing that, but it’s not really emanating from financial markets. In that sense, I think we’ve got good trading going on. We’ve got good price discovery going on. That part is working very well, at least so far.

I would say also though, we cannot hit the pause button for very long in major economies around the world, and certainly not in the US. I think there is a 90-day shelf life on this policy, maybe a 120-day shelf life. After that, you can’t continue the shutdown policy because too many other things will start to happen. You’ll get business failures on a grand scale and you’ll be taking risk that you go into depression. I really don’t think you can go too long with this policy. The shutdown policy is rational at the beginning where the pandemic catches everybody by surprise, and you really need to get the disease under control. But this is not a risk-based policy. It’s a blanket type policy, where all economic entities except those deemed essential are supposed to cease activity, and the economy can’t behave like that. You’ve got all these businesses and non-profit entities that have no revenue stream whatsoever. They might have some cash on hand. They might have some other ways to survive for a while, but that can’t go on indefinitely. You’ll get too many business failures and you’ll really do lasting damage.

We have to get away from the shutdown policy and towards something that is more about risk mitigation. We have lots of mortality risk around the economy and we have lots of ways of handling that mortality risk. A couple that I would like to mention are terrorism risk and traffic mortality risk. Both of those cases can be very dangerous. That doesn’t mean we shut the economy down. We take risk mitigating measures in order to control terrorism risk. We take risk mitigation measures to have traffic safety and to try to prevent fatalities there. I think the same thing has to be true for this disease, or any other disease. You have to get more granular about exactly how you want to handle the mortality risk and work toward that type of policy. The shutdown policy is way too much of a blanket policy where we’re just going to shut everything down. That isn’t working from an economic point of view and can only be done at the earliest phases of the pandemic, but longer term we’re going to have to get a lot better at this.

DM: Well, that’s right. And of course, it’s also extraordinarily expensive, isn’t it? If you just shift to where we are now, the deficit will clearly rise to 10%-11% of GDP. There’s a huge amount of funding that will have to be done. This is just while we’re in this present phase, but as you say it cannot last forever. There’s clearly a trade-off, isn’t there, between knocking everything on the head in this great blanket way, as you say, and the costs in even the world’s reserve currency cannot go on forever like this. You say it’s a 90-day issue. Are you reasonably confident that with this emergence from lockdown, which we’re seeing in very different pace in different parts of the US, we will in, say, another 90 days be in a better place and we’ll see some sort of gradual recovery starting to take shape in the third quarter?

JB: I do think that most of the damage will be right here in the second quarter. I think the forecasts are for GDP growth at an annual rate to be the most negative of all time. But the third quarter will come behind that with probably the highest GDP growth rate at an annual rate of all time as well. In some sense, you’ll have a very negative quarter followed by a group of positive quarters. Wall Street has the second quarter in the US being, you know on the order of a -40% at an annual rate. That’s a staggering figure and way beyond anything that was experienced in the post-war era in the US. And then the third quarter will probably be just the opposite, some big ‘plus’ number.

We do have an example of a country that had exactly this happen, which is China. It makes perfect sense. You’re asking these businesses to shut down. You’re asking people to stay at home. Of course, you don’t get very much output during that period and then you tell people that they can come back to work under certain safety restrictions. You’re going to get more output and it’s going to look like a high growth rate. I think macroeconomists have had a hard time getting their head around this shock and how different it is from all these past shocks that we’ve experienced. This is not the same thing and the numbers are way off the scale. We have to think about it a little bit differently than we have in other types of shocks.

DM: You’ve been helpful in some recent interviews by putting this into context of other pandemics, like in 1957 or 1968. Just staying for a while on this idea that it may not work and that the 90-day limit may be breached and we may be back into another scenario of a second wave or even a third wave. What other tools that the Fed have? Are you just going to continue to use your unconventional tools? You’re up to a balance sheet of about $6tn. Could you go into negative rates? I know this is an often-posed question to you, Jim. What other tools do you have in the box in case things do take a turn for the worse?

JB: We’ve talked about negative rates on and off over the years. It’s not a good solution in the US. We have different short-term funding markets than either Europe or Japan, and I don’t think it’s a very good option for the US. I also think that the track record is mixed both in Japan and in Europe as far as the success of negative rates, you’ll get an argument on that, but it doesn’t look like a panacea, that’s for sure. Probably more likely is a quantitative easing programme more explicit than what we have today in an attempt to keep rates low. I don’t think that this is really an interest rate story right now. Markets are not really hanging on questions about where rates are going to go. Everyone understands rates are going to stay where they are for quite a while. Maybe when we get into the second half of the year, we’ll get more sensitivity to rate policy. But right now, I think everyone just understands that we move the policy rate to zero and it’s going to stay there and that’s that.

DM: A very common question that you’ve always been asked, the last time between 2008-15. It took about six years for policy to start to be normalised. Throwing on your crystal ball, looking to the future, normalisation: is it just a ridiculous thing even to think about at the moment?

JB: I certainly wouldn’t worry about it at the moment. I don’t think normalisation worked all that well. When we were first talking about normalisation I was an advocate, but as it went on I started to wonder what were we trying to do with normalisation policy, because the entire time, inflation was actually running below target, so we were raising rates with inflation below target and we were having a hard time getting it toward target. It just became less and less clear what we were trying to accomplish and that made me think that it wasn’t that good of a policy, so I switched and started to argue against it. Japan and Europe are staying at low rates for the foreseeable future and I think the US will be right alongside them in this circumstance.

DM: Do you think that the unemployment numbers will get to a size where this is going to really cause social unrest? We are off the scale in terms of the unemployment rate. I think even in the Great Depression, we had 25% unemployment. Now on some levels it is going to be 30%.

JB: There’s no question. You’re taking a depression risk here in an experiment that is scaled at depression levels. I hope we can execute it properly and I do think it makes sense. My base case is that we can execute it properly but what we’re doing is asking people to stay home to get the disease under control, and we’re using the unemployment insurance programme in order to compensate people who’ve been disrupted by this health policy. We think that there are 47m workers at risk of losing their jobs over this, and we want to get them and keep them whole during this period and hopefully keep them in contact with their employers so that as we reopen they can go back to work. We should then get a sharp fall in the unemployment rate in the second half of the year. That could happen and that is my base case, but it could go badly awry.

You’re always taking a risk when you’re doing a one-time policy like this and that’s why I want to come back to the health policy. You can only play this card once, that you’re going to shut down the economy. You can only do that when you’re totally surprised by some disease that comes along. After that, you have to take a more careful approach, a more granular approach, a more risk-based approach. Show me exactly where the virus is. Show me how the virus is being transmitted. Mitigate those exact areas so that you limit the spread of the disease. It’s not feasible to just say, ‘every single person around the world has to go home and the world is going to plunge into deep depression’. We take mortality risk every day. We can manage this better and we will have to manage it better going forward. Also, we’re spending too much time thinking about vaccine coming to the rescue. There’s never been a vaccine for a virus of this type that I’m aware of, and I do not think we can just stay shut down until the vaccine comes along. That might never happen. Even if it does, the vaccine might not be all that effective, and the virus can mutate.

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