Author: Hubert Kucharski
Disclaimer: This article has been entered as an academic essay part of the Durham University Economics Society which has now concluded.
Date Submitted: 25th of April 2021
The following essay will analyse and evaluate the expansionary monetary decisions made by the Federal reserve regarding the COVID-19 Pandemic. The essay will comment on Monetary policy and its importance before explaining quantitative easing. After this, interest rates will be discussed and their theoretical and real-world impacts will be evaluated using the discount rate formula. This evaluation will allow the essay to decide if monetary policy has been a practical method of mitigating the effects of the COVID-19 Pandemic compared to Fiscal policy, once discussed, a further note will be made on how the Fed can mitigate future economic fallout.
Monetary policy, managed by the central bank of a nation, refers to the artificial creation of credit in the economy, quantitative easing, and the managing of interest rates and exchange rates. The latter, exchange rates, will not be examined as the Federal Reserve uses a free-floating exchange rate. This allows the Fed to instead manage the money supply of the economy and interest rate as the ‘impossible trinity’ does not allow for a pegged exchange rate system to be used alongside independent monetary policy and freely flowing capital (Sengupta and Aizenman, 2011). Therefore, the Federal reserve can only manipulate money supply or interest rates to mitigate the fallout of the COVID-19 Pandemic.
The main objective of the Federal Reserve however is hitting the 2% inflation target, but the Fed also looks towards achieving maximum employment (US Federal Reserve, 2016). So, when evaluating if the Federal Reserve has succeeded in mitigating the fallout of COVID, the current essay will look at inflation and unemployment data from throughout the pandemic. The start of the economic fallout induced by COVID within America can be pinpointed between March and April of 2020 where unemployment rose dramatically (U.S. Bureau of Labour Statistics, 2018a). Within that period, the March and April 2020 CPI inflation rate dropped significantly (U.S. Bureau of Labour Statistics, 2021). This places both the unemployment rate significantly above the naturally occurring rate of 3-5% and puts CPI inflation below the 2% target. Therefore, at the start of the pandemic, the Federal Reserve had to impose expansionary Monetary policy to motivate economic agents, this was done through cutting interest rates and quantitative easing.
Quantitative easing is a process where the Federal Reserve increases the supply of money within the economy. This was seen in March 2020, where the Fed announced the purchasing of various bonds and securities (U.S. Federal Reserve, 2020). This is designed to inject cash into the money supply of the economy as the Federal Reserve purchasing bonds from institutions or investors gives them an instant injection of cash. This increases liquidity as investors no longer have to wait for the bond to expire. This is done to prevent crowding out, when the US government issues bonds, investors have no spare cash to lend out to other economic agents, so, the Federal Reserve artificially creates money and buys these bonds from these investors to inject cash back into the economy thus increasing liquidity. Therefore, this ensures that investors have enough money to loan out to economic agents when borrowing is made cheaper due to cuts in the base interest rate.
In March, the Federal Reserve announced emergency interest rate cuts in the Federal funds rate (Islam, 2020). This cut in base interest is passed onto the interest rates set by banks as illustrated by the lowered inter-bank rates (TRADINGECONOMICS, 2021a). This cut in interest rates decreases the opportunity cost associated with borrowing, making investments much more attractive, a concept that can be mathematically illustrated using the discounted cash flow formula below (John Bickerton Williams, 1938).
The ‘r’ value within the formula refers to the riskless rate/discount rate, which accounts for various factors such as inflation and interest rates. This means when the base rate is cut, and the cut is passed onto commercial banks, the ‘r’ number decreases as the opportunity cost associated with borrowing is lower. So, because the denominator has decreased, the discount present value, (DPV) or the return on investment accounting for depreciation, is higher. Therefore, when interest rates are cut, businesses are incentivised to make an investment and borrow loans as the cash flow they will gain from the investment does not depreciate as much. Consequently, in theory, borrowing should increase and demand from business investment will rise, boosting aggregate demand in the American economy, helping the Federal reserve achieve inflation targets as demand-pull inflation occurs and unemployment is lowered as firms require additional workers to organically expand operations. Thus, expansionary monetary policy has helped the Federal Reserve motivate economic agents to achieve targets and mitigate the effects of the COVID Pandemic.
However, this formula is only practical in theory, this is because due to uncertainty, monetary policy only works if economic agents are confident. This highlights flaws in the discount rate formula as it only works if firms know the Future value, FV, of their investment. This is significant because, despite the Federal Reserve's announcements, business confidence remained extremely low between April and May of 2020 (TRADINGECONOMICS, 2021b). This means businesses were uncertain of the future, firms simply did not know if investments would make viable returns, for this reason, it is much harder for them to predict the FV value. Therefore, animal spirits and a ‘gut feeling’ play a much larger role in decision compared to the ‘r’ number as, without confidence, the discount value formula is incomplete and useless. Thus, without a reliable method of proving that investments will make returns, businesses don’t invest, aggregate demand decreases, and the Federal reserve's goal of using liquidity to stimulate the economy to hit inflation and unemployment targets has failed and standard monetary policy measures are simply not enough to motivate economic agents to mitigate the effects of the COVID pandemic.
Despite this incredibly low confidence in April and May of 2020, loans to the private sector in the US within this period were at their highest levels of the past 12 months (TRADINGECONOMICS, 2019). However, this increase in borrowing is likely not attributed to monetary measures such as cuts in interest rates, but rather, the fiscal policy measures that were introduced during that period. The Paycheck Protection Program was a substantial fiscal measure that introduced loans designed to keep workers on payroll (U.S. Small Business Administration, 2020). According to a research paper, the package led to a substantial increase in borrowing (Bartik et al., 2020). Further data also shows that the months following April 2020 began to see a decrease in unemployment (U.S. Bureau of Labour Statistics, 2018b). This means the increase in borrowing during these months has likely been due to the PPP as unemployment during these periods has also dropped. So, PPP increased business activity as establishments got busier with additional workers. Therefore, because of increased employment, firms spent more to grow their operations, increasing investment and boosting aggregate demand. This generated demand-pull inflation, as shown in the data (Ferreira, 2019a), whilst also reducing the unemployment rate. Consequently, fiscal stimulus efforts have been more effective at motivating economic agents making the policies more impactful in hitting inflation and employment targets and mitigating the effects of the COVID Pandemic compared to that of the Federal Reserves.
However, this does not necessarily undermine all of the Fed’s efforts in mitigating the economic fallout of the COVID-19 Pandemic. As previously illustrated, one expansionary monetary measure apart from cutting the federal funds rate is increasing the supply of money. This means if it wasn't for the Federal Reserve initially injecting $700 billion in April 2020 into the American economy (Liesman, 2020), all the private sector borrowing which occurred during that period would have been ‘crowded out’ by government bonds. Therefore, although safe government loans from the PPP were the main reason why borrowing increased, if it wasn't for quantitative easing measures, the inflation and employment boost which came as a result of such Fiscal measures would not be achieved, thus illustrating why the Federal reserve's monetary policy has somewhat successfully helped move towards achieving inflation and employment targets by minimising the economic downturn of the COVID-19 Pandemic.
But, looking forward, it may be possible that these fiscal and monetary measures have ‘overheated’ the American economy. Although the current inflation figure is within the boundaries of the symmetrical target, future inflation forecasts are predicted to go up to 3.8% CPI (Ferreira, 2019b). This means that the future inflation rate may be too high as demand-pull from the economic bounce-back has been too steep. Therefore, to ensure that inflation does not spiral out of control, the Federal Reserve should look towards implementing contractionary monetary policy to ensure that the CPI inflation rate remains within target in an effort to mitigate the economic fallout of the COVID-19 Pandemic.
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