In the face of mass economic and social disruption from the coronavirus epidemic, the Federal Reserve has been hard at work trying to shore up investor confidence and maintain liquidity in capital markets. The central bank has pumped liquidity into the repo market and has slashed interest rates to zero. Unfortunately, the Fed’s traditional tools have proven insufficient. Consequently, it has started to turn to more unorthodox strategies.
With the coronavirus-induced recession biting ever deeper, some analysts and commentators have started to wonder about other potential interventions. Nothing seems to be off the table. Indeed, some now think the Fed should push into equity markets.
Testing the waters
Until very recently, the idea of the central bank buying stocks was considered unthinkable. Yet, the idea has been gaining steam since the market crash this spring. In February, former Fed chair Janet Yellen helped break the taboo, suggesting that the Fed could end up buying stocks:
"[The Fed] might be able to help the U.S. economy in a future downturn if it could buy stocks and corporate bonds."
Current Fed officials soon took up the call and have floated a number of trial balloons in recent weeks. On March 6, Boston Fed President Eric Rosengren argued that, in the event that both short-term interest rates and 10-year Treasuries fall to zero, more unconventional asset purchases could prove essential to prop up capital markets:
“In such a case, as Marvin highlighted in his 1999 article, we should allow the central bank to purchase a broader range of securities or assets.”
Congressional approval needed
The Fed’s entry into the stock market is easier said than done. As Yellen pointed out on April 6, the U.S. central bank would need congressional approval to get into the equities game. But that could change. Yellen opined that while stock purchases by the central bank are not currently essential to prop up capital markets, Congress ought to consider giving the Fed the power to do so:
“It would be a substantial change to give the Federal Reserve the ability to buy stock. I frankly don’t think it’s necessary at this point. I think intervention to support the credit markets is more important, but longer term it wouldn’t be a bad thing for Congress to reconsider the powers that the Fed has with respect to assets it can own.”
While still restricted, it is easy to see Congress expanding the Fed’s mandate. No one in government wants to see a capital market rout – especially in an election year.
Finding a workaround
While the Fed is ostensibly barred from buying stocks, it may be able to find a loophole that does not involve a legal expansion of its mandate. It has done so already to support the corporate bond market, despite lacking a mandate to buy corporate bonds directly. Instead, it has financed special purpose vehicles that allow the Treasury to buy bond exchange-traded funds with the support of BlackRock Inc. BLK. A similar arrangement could be made for stock market ETFs. This is not mere speculation. Indeed, Rosengren suggested as much in his March 6 remarks:
“The Federal Reserve could consider a facility that could buy a broader set of assets, provided the Treasury agreed to provide indemnification.”
The Fed has proven remarkably inventive in stretching its mandate during this downturn. It seems likely that if the bear market persists and economic activity remains stalled, the central bank will push into stocks.
Verdict
From the time of his inauguration, President Donald Trump has publicly tied the success of his administration to capital market growth. Political pressure to expand the Fed’s capacity for intervention is mounting. Congressional leaders on both sides of the aisle must contend with political fallout if they fail to do everything they can to bolster the economy. Thus, there will likely be considerable pressure to change the rules to allow Fed equity purchases. Moreover, even if a legal change is not forthcoming, the central bank will likely consider using a workaround to do so irrespective of congressional approval.
It seems to be only a matter of time before the Fed dips its toes into the equities market.
Disclosure: No positions.
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