Federal Reserve Covid Response Monetary Policy

The COVID lockdowns of 2020 shuttered the economy overnight. The Federal Reserve was forced to act to prevent widespread damage. This paper looks at the interventions the central bank applied as well as at the upside and downside of these actions.

The first thing the Federal Reserve did was to ease credit by cutting interest rates to near zero—which means there was no virtually no cost to borrow. The point of this was to encourage borrowing and spending so that the recession resulting from the lockdowns would not deepen to something akin to a depression. The Federal Reserve also had to take care of credit market and thus gave out short-term loans to major banks so that there were no disruptions. It made sure that businesses had access to short-term credit to keep operations going. It extended credit to small businesses that were adversely affected by the lockdowns. It also supported banks in the Paycheck Protection Program, giving forgivable loans to small businesses (essentially free money to businesses who wanted to keep employees on payroll during the lockdowns).

The Federal Reserve also had to supply liquidity by buying Treasuries and mortgage-backed securities in a continuation of its policy of quantitative easing (QE), which it launched in reaction to the 2008 Great Financial Crisis. Buy buying Treasuries it sought to lower long-term rates, bring stability to the markets (which went into freefall in 2020), and promote lending and investment. To that end, the central bank also issued forward guidance, indicating that rates would remain near zero for some time. This was meant to encourage capital investment rather than flight (Bernanke, 2022).

The impact of all these actions on aggregate demand was that it made it cheaper for consumers to borrow, meaning they were also more likely to spend—and spend they did: real estate prices soared as demand went up. Used car prices went up. Eventually, though, prices of everything went up as inflation finally was felt across the board. It was also cheaper for businesses to borrow. There was a V-shaped recovery in the stock market, once investors realized the Federal Reserve was going to act as the ultimate backstop to prevent a longer recession from occurring, i.e., the lender of last resort as Assouad (2021) states. The Federal Reserve supported the government’s interventions, like the CARES Act, by keeping rates low so that the government could finance the fiscal programs without immediate worry. The Federal Reserve’s monetary easing also fueled USD depreciation, which made US exports more competitive and which increased demand for US goods and services overseas. These steps were all part of the process of preventing the lockdowns from utterly destroying the US economy. If the lockdowns were necessary for health reasons, then so too was this intervention for business reasons.

The risks, however, were clear—inflation and stagflation. First, the risk of inflation: this was an obvious one, and it is why the price of gold has nearly doubled in the past five years. When the central bank increases the money supply dramatically and quickly and keeps interest rates low for a long time, it acts as an inflationary pressure (Afrouzi et al., 2024). Demand outpaces supply because buyers now are flush with cash and want to get out of it as soon as possible as they know the central bank is simply devaluing USD as an asset (look at a 100-year chart, it is obvious, and is another reason people have been getting into crypto like Bitcoin). Some argue it was supply chain disruptions and increased consumer demand or rising wages that fueled inflation—but the simplest answer is always the best: the Federal Reserve printed off trillions, and the memes of Chair Powell flooding the markets with cash were launched. Everyone knew what was happening, and everyone went out to spend as fast as they could, knowing prices would never come down to where they were again.

That was not the only risk, however. The other was stagflation, which is when unemployment is high, inflation is rising, and economic growth is stagnant. The economy is not growing like it should in spite of central bank intervention. This could be due to supply chain issues (tariffs and the like), rising energy costs (wars and the like), restrictive monetary policy (to reign in inflation, the Federal Reserve would inevitably have to raise rates, which would impact business investment of supposedly strong businesses but definitely of zombie companies). Stagflation is the reality, however, that your centralized economy is entirely dependent on governmental largesse, and that as soon as the free money and loose credit are ended, the economic life dies because it cannot function without life support.