Here’s what you need to know.
1. The Fed quickly moved into crisis-fighting mode
Last Thursday, the Fed announced it would offer $1.5 trillion in short-term loans to push cash into money markets. Then, over the weekend, it dropped interest rates to zero and resumed buying bonds, both efforts last used during the global financial crisis from 2007 to 2010. The Fed then announced it would launch a $10 billion special fund to help keep credit flowing to households and business. This weekend, the Fed also revved up its “currency swap lines” with five major foreign central banks: the Bank of Canada, Bank of England, Bank of Japan, European Central Bank and Swiss National Bank. The move makes U.S. dollars available overseas at cheap rates, as the global battle with the covid-19 pandemic grows increasingly severe.
Or, to put it more colloquially, the Fed fired a bazooka. Dropping rates to zero means that the Fed is exhausting its normal monetary policy discretion, since Fed Chair Jerome H. Powell has indicated that the central bank is unlikely to lower rates below zero. By resuming bond buying and reaching for swap lines, the Fed has taken its Great Recession playbook off the shelf to deploy against the pandemic’s economic consequences.
2. Reaching for ‘swap lines’ suggests global financial threats
Enhancing the swap lines signals that extraordinary steps may be needed to stabilize the global economy. Swap lines ensure a sufficient supply of U.S. dollars in global financial markets, where the greenback is by far the most used currency. When the economy is healthy, currency swaps are seldom needed; when access to dollars is scarce, swap lines provide an important lifeline. During the Great Recession, the Fed extended swap lines to 14 foreign monetary authorities — and added, at the peak, nearly $600 billion in dollar liquidity into the world’s financial system.
Here’s how swap lines work. Swap agreements involve two transactions between the Federal Reserve and a counterparty central bank. In the first transaction, a foreign central bank sells an amount of its currency to the Fed in exchange for dollars, at the market rate. The Fed holds this foreign currency in the counterparty’s account at the Federal Reserve Bank of New York for a specified period. The foreign central bank obtaining dollars loans them to financial institutions in its jurisdiction in times of stress.
At the end of the specified period, which ranges from an overnight exchange to as much as 90 days, the second transaction unwinds the first. The foreign central bank buys back its currency from the Fed in exchange for dollars at the same market exchange rate. By drawing on a Fed swap line, the foreign central bank pays interest to the Fed equal to the amount it earns on its domestic operations, at a market-based rate. Thus, this is not a “bailout” but a liquidity “swap” to ensure access to those who need cash in particular currencies.
3. Domestic and international considerations motivate these actions
Several international and domestic dynamics shape these global currency policies.
First, as Daniel McDowell shows here, the Fed used these “international lender of last resort” powers during the global financial crisis as a defensive maneuver: Opening swap lines protected the U.S. economy from spillover threats, like bank defaults, from foreign economies facing financial difficulties. In a globalized economy, stabilizing global currency markets bolsters the U.S. economy, improving the Fed’s ability to meet its congressional mandate to maximize employment and stabilize prices. The Federal Reserve’s announcement this weekend reiterated this mandate.
Second, not every country that wants a swap gets one. Aditi Sahasrabuddhe shows that central bankers are more likely to grant a swap to countries that share the U.S. preference for greater capital openness, with an eye to reinforcing economic alliances. So far the Fed has excluded some economies such as Singapore and South Korea that received swaps in 2008 but do not currently have standing Fed swap lines; unlike in 2008, these countries do not currently enjoy leading roles in global economic governance institutions. What’s more, during the pandemic, capital is rapidly fleeing these and other large and emerging markets, as investors search for safer havens to park their money. The Fed may later expand the swap program to include these and other economies, as some argue it should.
Third, Kindred Winecoff emphasizes that because most international trade and financial transactions are invoiced in dollars, access to dollars is essential for global commerce. This makes the Fed the most important global economic player: Only the Fed can make dollars available to foreign central banks to facilitate lending in dollars abroad. The Fed’s swap lines empower U.S. policymakers to influence the global economy in ways that are congruent with U.S. interests.
4. The Fed’s actions might be a double-edged sword
The Fed probably sought to calm financial markets by moving before markets opened Monday morning, given last week’s extreme volatility. But the Fed’s aggressive actions also signaled that the financial system is more at risk than many realized. Fiscal and monetary authorities will probably have to provide more public support for the world economy.
That may be why markets fell precipitously after the Fed’s actions, prompting the South Korean finance ministry to pledge “swift and stern stabilization measures” then echoed by policymakers around the world. What’s more, several governments — including Australia, India, South Korea and the United Kingdom — suggested an emergency meeting of the Group of 20 governance group might be needed.
Parallels to the 2008 financial collapse abound. By once again deploying its crisis tool kit, Fed officials indicated that the pandemic could drive the global economy into a more severe shock than anything seen in more than a decade.
Daniel McDowell is associate professor of political science at the Maxwell School at Syracuse University.
Aditi Sahasrabuddhe is a PhD candidate in government at Cornell University.
Kindred Winecoff is associate professor of political science at Indiana University at Bloomington.