The Fed’s Liquidity Confusion
The most essential function of the Federal Reserve is to provide money, or liquidity, to the financial system. The Fed is responsible for ensuring that the supply of money is equal to the total amount demanded. It is not responsible, however, for ensuring that each company and municipal government has sufficient cash to meet its obligations.
Fed Chair Jerome Powell recently testified to Congress regarding the Fed’s response to the coronavirus outbreak and lockdown. In addition to cutting interest rates to near zero, Powell described the Fed’s “forceful measures in four areas:”
The first three areas listed by Powell deal with financial market liquidity and thus lie within the territory of a prudent central bank. The fourth area does not.
The Fed’s broadest form of liquidity provision involves supplying money to the economy. The Fed attempts to influence money in the economy so that the quantity supplied is equal to that demanded for economic transactions. To help promote stability in the financial system, the Fed also supports financial market liquidity by buying and selling securities and encouraging companies to lend to one another.
A third type of liquidity, known as “balance sheet liquidity” or “asset liquidity,” has to do with the salability of bank assets. The Fed’s website describes this type of liquidity as “the cash and other assets banks have available to quickly pay bills and meet short-term business and financial obligations.” Bank deposits can be withdrawn at any time, so banks must maintain adequate cash reserves to meet these potential liquidity needs.
Bank liquidity is also important from an economic perspective. It enables lending, which allows the economy to function and grow. In addition to providing liquidity to the economy and financial markets, the Fed supports liquidity in the banking system by regulating banks’ liquid asset holdings and, when necessary, lending to banks directly.
In contrast, lending to nonbank companies does not improve liquidity in the financial system. Unlike banks, nonbank companies do not generally lend money to other companies. Hence, lending to nonbank companies does not promote credit or increase liquidity in the broader economy. For this reason, the Fed has historically refrained from lending to nonbank companies except on rare occasions when a company has direct ties to the banking system.
In his testimony, Powell misapplied the term “liquidity” in support of the Fed’s nonbank lending facilities, such as the misnamed Municipal Liquidity Facility (MLF). As he described the MLF, “we have a liquidity facility that is there to address the short-term liquidity needs that these [municipal] entities have.” Describing the Fed’s other lending programs, he said, “Generally with 13(3), what we’re trying to do is address liquidity needs.”
What Chair Powell calls “liquidity” is really credit allocation. The Fed is not merely providing liquidity to the financial system. It is distorting the allocation of credit by lending to some entities and not to others.
This is the one “area” mentioned in Powell’s testimony that is clearly outside the territory of a prudent central bank: lending to households, businesses, and state and local governments. These activities are not the Fed’s job. Fed officials have traditionally been reluctant to engage in such actions since they are political, fiscal policies that threaten the Fed’s independence. As former Fed Chairs Ben Bernanke and Janet Yellen have argued, lending to municipal governments and nonbank companies are fiscal policies with which the Fed should not be involved.
Powell said the Fed’s programs would “facilitate more directly the flow of credit to households, businesses, and state and local governments.” In fact, the Fed is creating credit, not just facilitating the flow.
Powell also stressed the limits of the Fed’s authority, saying: “What we do is address liquidity problems, not solvency problems. We have lending powers, not spending powers.” However, the Fed is only responsible for liquidity problems in the banking system, not those of nonbank entities. In addition, the Fed is exercising spending powers through its lending facilities by providing loans at below-market rates.
The Fed is responsible for creating liquidity by supplying money to the economy and supporting the banking system. These basic functions of a central bank should not be confused with satisfying the cash needs of municipalities and nonbank companies.
Fed lending to nonbank companies and municipalities is not liquidity provision; it’s credit allocation. It’s an area in which the Fed should not be involved.
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