Asset price spirals and the Fed

The Fed is right to shore up the financial system

The Covid-19 shock is primarily a real (non-financial) shock that reduced aggregate supply but also generated a large reaction in financial markets that had the potential to significantly depress aggregate demand beyond the decline in supply. The Fed (with the backing of the Treasury) had to pledge close to 20% of US GDP in funding for a wide range of credit and market supporting facilities to stop the free fall. In this paper Caballero and Simsek develop a model:

…of endogenous asset price spirals and severe aggregate demand contractions following a large supply shock. The key mechanism stems from the drop in the wealth share of the economy’s risk-tolerant agents: as a recessionary supply shock hits the economy, their wealth declines and their leverage rises endogenously, causing them to o­ffload some risky assets. [If] the interest rate policy is constrained, new contractionary feedbacks arise: recessionary supply shocks not only feed into reduced risk tolerance but also into further asset price and output drops, which feed the risk-off episode and trigger a downward loop. When pre-shock leverage ratios are high, multiple equilibria are possible, including one where risk-tolerant agents go bankrupt. A large-scale asset purchases (LSAPs) policy can be highly effective in this environment, as it reverses the downward asset price spiral. The Covid-19 shock and the large response by all the major central banks provide a vivid illustration of the environment we seek to capture.

A Model of Asset Price Spirals and Aggregate Demand Amplification of a “Covid-19” Shock
Authors: Ricardo J. Caballero, Alp Simsek
From: MIT

Maybe the Fed is going too far?

The Fed has felt the need to take over essentially all new lending in the economy. The Fed is also propping up most fixed-income prices. The Fed is deliberately removing risk from holding these assets.

Once again, I will be told, “this isn’t the time to think about moral hazard.” But having done this twice, the first time with huge protest, the second time as if it is perfectly normal, this is the pattern, and the moral hazard is there. The economy will load up on debt, especially short term debt. People will not keep stashes of savings around to provide liquidity or jump on buying opportunities. And the need for bailouts will be larger in the next crisis.

Bailout redux
By: John Cochrane – Stanford University