Examining the influence of the Federal Reserve on the economy during COVID-19

Can one central bank system control or even influence the US economy as it desires? After several financial panics during the 1900s, the Federal Reserve System, commonly known as the  Fed, was founded through the Federal Reserve Act on December 12, 1913. Initially, the Fed was the central system that controlled the monetary system to reduce the impact of financial crises (Federal Reserve Bank of Minneapolis, 1998). After experiencing economic recessions with global impacts like the Great Depression and the Great  Recession, the Fed had to expand and take more responsibility (Federal Reserve Bank of St.Louis, 1913). Today, the Fed is the controller of the monetary system and the economy. The Fed has locations all over the US and has divided the country into twelve districts, each with reserve banks.

The Fed holds several tools to regulate money and the economy. The Fed controls the monetary system to regulate the money market and the aggregate demand. The Fed's principle to control the money supply is that the total money supply correlates with the money multiplier and the monetary base. Therefore, the Fed’s tools can be categorized into two types: manipulating either factor. The Fed’s traditional methods include open market operations and discount rates to change the monetary base. The Fed developed unconventional tools like quantitative easing to deal with special periods like the Great Recession. Additionally, the  Fed changes the money multiplier by exerting requirements or raising interests on the reserves, a portion of deposits banks keep themselves.

However, it must be noted that the Fed does not have complete control of the money supply and the economy. The reasons are that the Fed can not control how much cash households hold and how many reserves banks keep. The Fed can control the interest rate, which then influences aggregate demand, impacting price level and output. 

Over the recent decades, many voices have criticized the Fed for losing control of the economy and having less impact. Such doubt became particularly strong after COVID-19 when scholars argued that the Fed no longer has control over the economy. I will briefly examine whether the argument that the Fed is losing control of the economy holds.  

The outbreak of COVID-19 in early 2020 was an unusual shock to the US economy. A  typical shock to the economy involves either demand or supply, like the 1980s oil shock, which was a negative supply shock. However, the Covid shock impacted both the supply and demand. Initially, COVID-19 influenced long-run aggregate supply as businesses closed or slowed down due to supply chain issues. As a result, consumers lost the ability to spend money, and the reduction in demand,  especially in retail and hospitality, due to lockdowns led to a significant decline in aggregate demand. To fix the economic recession caused by COVID-19, the Fed took several actions to support the financial market and the economy. 

The Fed began by reducing the federal funds rate: the rate banks pay to borrow from each other overnight. The Fed continued adopting quantitative easing by purchasing $500 billion of Treasury securities and $200 billion of mortgage-backed securities on March 15, 2020, hoping to boost the economy by decreasing interest rates (Brookings). In June 2020, the Fed set to purchase $80 billion of Treasuries and $40 billion of mortgage-backed securities (Brookings).  From December 2020 to December 2021, the Fed continuously slowed down the amount of purchases each month, making the public question the effectiveness of the purchasing.  

Second, the Fed relaunched several programs and facilities, hoping to boost borrowing but not all actions worked as expected. The Fed used the Primary-Dealer-Credit-Facility, offering limited-time, low-interest rate loans to large financial institutions, hoping to keep the credit markets operational. The Fed also picked up the Mutual-Fund-Liquidity-Facility, offering loans to eligible financial institutions that were willing to collateralize high-quality assets but had to shut it down on  March 31, 2021, along with PDCF, given the limited usage (Brookings). The Fed expanded the repo operations, a platform for firms to borrow and lend cash and short-term securities overnight, and made the  Standing-Repo-Facility permanent. Furthermore, the Fed also established Foreign and International  Monetary Authorities that offered funds to foreign central banks and built swap lines.  

Third, the Fed provided more lending to businesses. The Fed established the Primary Market-Corporate-Credit-Facility and Secondary-Market-Corporate-Credit-Facility, which allowed the Fed to directly bond and lend loans to corporations. The Fed sold all its corporate bonds by  January 2022. To better support small and mid-sized businesses, the Fed launched the Main Street Lending Program and Paycheck-Protection-Program and prepared $600 billion in five-year loans (Brookings). The Main Street Lending Program also opened to non-profit organizations such as hospitals and schools, and the principal’s payment in the first two years was deferred. Finally, the Fed supported households and governments through loans. The Term-Asset-Backed-Securities-Loan-Facility supported student loans, credit card loans, etc. The Fed also provided loans to governments struggling to exchange future tax revenues.  

The central bank of the United States still has control over the monetary system and the economy, but it seems like the Fed is making less of an impact. Such a phenomenon is because the  Fed controls the financial market and flow of money, which are only parts of the economy. The actions of lending money and controlling the money supply have little impact on the supply side of the economy and real factors. In other words, what the Fed is capable of doing only covers short-term regulations but not any long-term trends. The recession brought by COVID-19 was an important experience for the Fed as the public health issue helped the Fed to understand how to be more responsive to unusual economic recessions.

Edited by Raghav Agarwalla

References

Born of a panic: Forming the Federal Reserve System. Federal Reserve Bank of Minneapolis. (1998). https://web.archive.org/web/20080516102508/http:/minneapolisfed.org/pubs/region/88-08/reg888a.cfm 

Congress. (1913). Federal Reserve Act. Federal Reserve Bank of St. Louis. https://fraser.stlouisfed.org/title/federal-reserve-act-975. 

Liang, N., Sage Belz, L. S., Kohn, D., Robert Maxim, M. M., & Wendy Edelberg, O. H. (2024). What did the Fed do in response to the COVID-19 crisis?. Brookings. https://www.brookings.edu/articles/fed-response-to-covid19/.

Freepik. (n.d.). COVID-19 coronavirus in USA, 100 dollar money bill with face mask. Crisis and finance concept [Photograph]. Freepik. https://www.freepik.com/premium-photo/covid-19-coronavirus-usa-100-dollar-money-bill-with-face-mask-crisis-finance-concept_8114848.htm