Fed must elastically supply liquidity to ensure functioning of markets, sufficient cash for businesses

Professor and Michael P. Grace II Collegiate Chair of Economics Eric Sims is available to comment on the interest rate cut and other Fed issues during this uncertain time. His initial comments are below. You can reach him at [email protected].

“The economic harm caused by the coronavirus pandemic is likely to be severe. We are undoubtedly headed to a recession. At this point, recession is likely both unavoidable but also even optimal from a public health perspective — we don’t want people interacting with one another, which necessitates a reduction in economic activity.

The Fed itself has limited tools to contain the likely coming recession. What they are (or should be) concerned about is liquidity pressures that have the potential to significantly harm the recovery once the pandemic has (hopefully) subsided. Many small businesses rely upon cash flows to remain operative. Many larger businesses have high debt burdens and the coming decline in cash flows has the potential to significantly harm their balance sheets. What the Fed should and must do is elastically supply liquidity to ensure functioning of markets and that business have sufficient cash to remain open. Several of their operations over the last week — including the opening of the $1.5 trillion reverse repo facility, the cut in the discount rate, and the extension of the term on discount loans — are targeted toward providing liquidity and quelling panic-based asset sales.

It is less clear to me whether cuts in the policy rate (i.e. the Federal Funds rate) are beneficial or warranted. Economic activity is declining not because interest rates are too high, but rather in response to health concerns. Lowering interest rates to stimulate activity seems misguided. Indeed, financial markets have reacted in such a way that cuts in the FFR are being interpreted as signals that things are worse.”

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