18

Responding to the Great Pandemic

The scope of the crisis required an all-in government response.

—JEROME POWELL, WALL STREET JOURNAL, MARCH 19, 2021

The COVID-19 pandemic, which began in China late in 2019, reached the United States in January 2020, with the first U.S. case confirmed on January 20 and the first death attributed to COVID recorded on February 29 in Washington state.¹ The spread was frighteningly rapid. By May 1, 2020, the cumulative number of confirmed cases in the United States was about 1.12 million, and over 68,000 people had died. By the end of 2020, those numbers were roughly 20 million cases and 352,000 deaths. By the end of 2021, they were a staggering 56 million cases and over 800,000 deaths—and rising. Worldwide numbers were, of course, multiples of U.S. numbers.

The pandemic was, in the first instance, a public health catastrophe of the first rank, the worst since the badly misnamed Spanish flu pandemic of 1918–1920. But it also brought on an economic catastrophe with blinding speed. The recession of 2020 was the deepest contraction the United States had witnessed since the 1930s, dwarfing the Great Recession of 2007–2009, and by far the sharpest recession ever. For comparison, the peak-to-trough decline in real GDP over the six quarters from 2007:4 to 2009:2 was 4 percent, while the decline in 2020 was 10.1 percent, almost all which occurred in a single frightening quarter: 2020:2. Real GDP in that dreadful palindromic quarter declined at a mind-numbing 31.2 percent annual rate, cutting this comprehensive measure of economic activity all the way back to its 2015:1 level.² The unemployment rate soared to almost 15 percent.

At first, most of that horrific decline was laid at the doorstep of government-ordered lockdowns. But subsequent examinations of high-frequency data from a variety of unconventional sources soon showed that people stopped shopping, traveling, going out to restaurants and movies, and so on well before any shutdowns were ordered.³ What happened in the United States and in other countries was pretty simple and pretty devastating: fear ran rampant, and absent any proven medical interventions, people just pulled away from one another as they had during the plagues of centuries gone by.

Even in this electronic age, human contact is an essential part of economic activity, and human contact suddenly looked dangerous. People and businesses quickly learned which economic activities could be conducted online and which could not. On the employment side that division was, sadly but obviously, highly skewed toward upper-income and better-educated segments of the population, many of whom normally worked at computers anyway. They suffered relatively small losses of earnings, if any. Less educated workers, whose jobs were in restaurants, hotels, retail shops, and the like, lost far more. Once recovery began, it was labeled K-shaped to connote that upper-income groups fared well while lower-income groups remained mired in recession longer.

In addition to the astonishing speed of the decline, another highly unusual aspect of the recession of 2020 was its concentration in consumer expenditures and especially in spending on consumer services, which not only collapsed but came back agonizingly slowly. In previous business cycle downturns, consumer spending normally held up well compared to, say, business investment and housing, and spending on services barely registered any declines at all. In 2020, however, many service jobs that we thought of as noncyclical suddenly disappeared in droves.

By March, there was little doubt that both fiscal policy and monetary policy had to respond quickly and massively. Both faced challenges. But there was little doubt that fiscal policy had to do the heavier lifting this time around because monetary policy had little conventional ammunition left. The Fed’s target range for the federal funds was 1.5–1.75 percent on March 1, 2020. By March 15 it was down to 0–0.25 percent, which was the Fed’s effective lower bound.⁴ This meant that asset purchases on a grand scale, in the style of quantitative easing (QE), would be required. So would deficit-financed public spending by the federal government. The budget-deficit ogre would have to be put back in its cage again.

First Responders: Fiscal Policy

Federal spending is the province of Congress, of course, and the U.S. Congress responded to the clear and present danger posed by the coronavirus extremely aggressively. A series of emergency response bills started small with an $8.3 billion supplemental appropriation to the fiscal year 2020 budget, enacted on March 6. At the time, the economic impact of the virus was barely registering; the earliest shutdowns and stay-at-home orders were still a week or two away. Understandably, that first dollop of money was appropriated mainly for public health purposes, including vaccine development. The bill contained nothing controversial and garnered near-unanimous support in both houses of Congress. No one knew at the time that the $8.3 billion would turn out to be the tiniest tip of a gigantic iceberg.

Within two weeks the World Health Organization declared the novel coronavirus to be a global pandemic, and Congress passed the much larger ($104 billion) Families First Coronavirus Response Act, again with huge majorities in both the House (363–40) and the Senate (90–8). That law provided for paid sick leave at an employee’s full salary (up to $511 per day), legislated paid family leave at two-thirds of a parent’s usual salary, required Medicare and private health insurance plans to cover COVID-19 testing, and expanded unemployment insurance (though ever so slightly). The usual resistance to public spending was largely dissipated by widespread recognition that the United States was facing a national emergency, though no one knew how dire that emergency would turn out to be.

But in perhaps an omen of things to come, all 48 “no” votes in Congress were cast by Republicans. Still, the fact that 140 House Republicans voted “yes” showed that few people in Washington were seeing things through partisan lenses in mid-March, except perhaps for Donald Trump, who seemed to see everything that way. In his eyes, the Democrats, the press and the Chinese were ganging up on him to make a big deal over a disease that would soon disappear on its own. On March 10, he advised Americans that “it will go away. Just stay calm” (Colvin 2020). On March 22, referring to state-ordered lockdowns, he declared that “we cannot let the cure be worse than the problem itself” (Haberman and Sanger 2020), and two days later he said that “I would love to have the country opened up and just raring to go by Easter” (Watson 2020), which was just two and a half weeks away.

As they say, hope is not a plan. And COVID-19 was spreading like wildfire. The daily count of confirmed cases in the United States (based on the seven-day moving average) rose from just 13 on March 1 to 436 on March 15 and to almost 21,000 by April 1. President Trump may have been assuring everyone that it would be all but over by Easter, but the American population and Congress were frightened. Late in March, after a bit of partisan wrangling, Congress passed the enormous Coronavirus Aid, Relief, and Economic Security (CARES) Act, with a price tag of around $2.2 trillion. It still stands as the largest spending bill in history; President Joe Biden’s American Rescue Plan (ARP) in March 2021 clocked in at $1.9 trillion. Partisanship was set aside in passing CARES by a voice vote in the House and by 96–0 in the Senate, with 4 Republicans not voting. President Trump signed the bill into law on March 27. On that day, 417 Americans died of COVID-19. By April 15, that number would be 2,289.

To put the size of the CARES Act into perspective, $2.2 trillion amounted to more than 10 percent of GDP and was almost exactly half of total federal spending during the previous fiscal year. The scope of CARES was equally impressive. Its long list of major provisions included, among other things, the following:

·                    Checks in the amount of $1,200 for “every” adult ($2,400 for a married couple and $500 per child). In fact, however, millions of low-income Americans received nothing because the checks were paid out as rebates on 2019 tax liabilities, and they were too poor to have filed income tax returns.

·                    The Paycheck Protection Program (PPP), originally budgeted at $366 billion but quickly oversubscribed, which provided forgivable loans (thus, really grants) to “small” businesses that maintained their payrolls. (Some weren’t all that small.) About four weeks later, Congress infused a great deal more money into the popular program via the PPP and Health Care Enhancement Act ($484 billion in total), another noncontroversial bill that passed with bipartisan support.

·                    A huge increase ($600 per week) in unemployment insurance benefits plus extension of coverage to many previously uncovered workers. To economists, the $600 flat amount was an odd structure; it meant that about two-thirds of American workers would receive more income by being unemployed than employed (Ganong, Noel, and Vavra 2020).

·                    About $150 billion in aid to struggling state and local governments. Aid to states and localities would later become a major partisan sticking point, with Democrats wanting more and Republicans steadfastly opposed. Some people, it seemed, had noticed that COVID-19 in its early stages was mostly a blue states phenomenon.

·                    A large bailout for the airline industry and grants to other transportation industries, all of which had been decimated by the pandemic. Airlines, of course, had gone through bankruptcies before, but this time they did not have to.

·                    Over $180 billion in health and health-related spending.

·                    A variety of business tax cuts amounting to about $280 billion. These were not among Democrats’ favorite provisions.

·                    Moratoria on foreclosures and evictions though without enforcement mechanisms.

Taken together, this was powerful fiscal relief. The transfer payments to individuals—mainly the “rebate” checks and the extra unemployment benefits—created an unprecedented situation in which disposable income actually went up in 2020, even though earnings crumbled. That stunning development helped support consumer spending even though most of the transfers were saved. The personal saving rate reached heights never seen in America (figure 18.1). Well over $2 trillion in “excess” saving was accumulated in 2020 and 2021; much of it wound up in bank accounts.

By summer, several of the major provisions of the CARES Act were drawing to a close, and many more were set to expire by December. Democrats, who then held the majority in the House but were in the minority in the Senate, began agitating for another emergency relief bill, but Republicans were not convinced of the need. Among other reasons, the economy started to revive in June. In the third quarter (July–September), real GDP growth soared at a 33.8 percent annual rate, thereby making up most of its sharp second-quarter decline. Real GDP in 2020:3 stood just 3.3 percent below its 2019:4 level. In addition, the budget deficit had soared to levels previously thought unimaginable, and some Republicans “remembered” that a large deficit could be a problem.

FIGURE 18.1. Personal saving rate, monthly, 2020–2021.

Source: Bureau of Economic Analysis.

The two parties deadlocked for months over two issues in particular. Democrats wanted to send much more federal aid to state and local governments. Republicans, seeing that much of the money would flow to the more heavily impacted blue states, opposed that. Instead, they wanted to provide legal protections for employers whose workers might become ill from workplace exposure, an idea Democrats opposed. With a modicum of bipartisan comity, those two issues could have been compromised away. But bipartisanship had disappeared by then, giving way to months of rancorous partisan sniping with little movement on either side.

Finally, with end-of-year expiration dates of several key COVID relief programs concentrating the minds of legislators, the four congressional leaders—House Speaker Nancy Pelosi (D-CA), Senate majority leader Mitch McConnell (R-KY), Senate minority leader Chuck Schumer (D-NY), and House minority leader Kevin McCarthy (R-CA)—hammered out a deal with roughly $900 billion in new COVID relief. The package included $600 checks to most Americans (including children), $300 per week in enhanced federal unemployment benefits (until March 14, 2021), and another large dollop of funding (over $280 billion) for the immensely popular (though poorly designed) PPP.

At the eleventh hour President Trump, never a piker, threw a monkey wrench into the negotiations by proclaiming that the checks should be for $2,000, not $600. Many Democrats—including President-elect Joe Biden—warmly embraced the $2,000 figure, but Republicans did not, and Congress stuck with the agreed-upon $600. Despite calling that paltry sum a “disgrace,” President Trump signed the bill into law just after Christmas. Biden insisted that more aid would come once he became president. Meanwhile, Trump stubbornly refused to concede that he had lost the 2020 election. In fact, he never did concede, hewing to what came to be called the Big Lie: that the election had been stolen from him by a wide variety of illegal acts, none of which proved to be true.

Ironically, two runoff elections for Georgia senators were scheduled for January 5, and the Democratic challengers (the two incumbents were Republicans) ran in part on supporting Trump’s $2,000 checks. In a huge surprise, they both won, thereby making the Senate an even 50–50 split, which effectively made the Democrats the majority party because Vice President–elect Kamala Harris could cast the deciding vote if the chamber deadlocked 50–50. That 50–50 Senate “majority” would quickly prove to be incredibly important.

On the very next day, January 6, 2021, Americans suddenly had a lot more than relief checks to worry about as a crowd of over two thousand Trump supporters stormed and vandalized the U.S. Capitol, demanding that the Senate—with Vice President Mike Pence still presiding—not certify the electoral college count. Pence and the Senate refused their demands, though many Republican members of both houses of Congress continued to spout the Big Lie.

First Responders: Monetary Policy

While fiscal policy acted fast, monetary policy acted even faster. The Federal Reserve’s initial policy response to the threat posed by the pandemic—a drop of 50 basis points in the already-low federal funds rate—came at a hurriedly arranged Federal Open Market Committee (FOMC) meeting on March 3. The committee’s statement that day observed that “the coronavirus poses evolving risks to economic activity” (FOMC 2020a), which subsequently proved to be quite an understatement. (But the Fed never wants to frighten people.) Two painfully obvious problems faced the Fed, however.

One was that when a central bank starts an easing cycle with an overnight rate in the 1.5–1.75 percent range, there is a sharp limit to how much rate cutting it can do. In past recessions, which were far less severe than that of 2020, the Fed had often cut rates by 500 basis points or more to boost aggregate demand and end the downturn. But in the pandemic recession, the FOMC limited itself to 150 basis points of rate cutting, which it finished doing on March 15, just twelve days after it started.

The second big problem for monetary policy was speed, but not speed in decision making; as just noted, the FOMC moved with alacrity. Rather, the speed issue stemmed from the well-known lags between interest rate changes and their effects on spending. Econometric estimates of these lags in normal times showed small effects in the first few quarters after a Federal Reserve action, building into larger effects after, say, six to eight quarters. In the crisis atmosphere of 2020, that would plainly be far too slow. Would the effects of expansionary monetary policy arrive faster in such desperate times? Or, as seemed more likely, would the interest sensitivity of spending on new automobiles and new homes be attenuated because people were afraid to go shopping?

But that wasn’t the end of the Fed’s problems. There is, of course, two-way contagion between financial markets and the real economy. Ructions in the financial world can disrupt the normal credit-granting mechanisms and, by dint of that, imperil real economic activity—as happened dramatically in 2007–2009. But damage to the real economy can also cause severe problems, even panic, in financial markets, as it did in February and March 2020. So, the Fed’s attention quickly turned to stabilizing the financial markets. The central bank was powerless to stem the spread of the virus or even to reduce the fear of shopping, but it could nip financial panics in the bud.

As traders started processing the economic hazards that lay ahead and the huge uncertainties they posed, stock prices cratered. The S&P 500 began dropping on February 19, gradually at first but then dramatically in March (figure 18.2). Between March 11 and March 23 (which turned out to be the market’s bottom), the S&P lost a stunning 22.4 percent in just nine trading days. The total peak-to-trough decline from February 19 to March 23 was a confidence-shattering 33.8 percent in little more than a month. As figure 18.2 shows, the stock market recovered remarkably quickly, however, regaining all those losses by mid-August and then going much higher.⁵ But no one knew that in March, and few dared dream it. The Fed is normally content to pay little heed to stock market gyrations, but a drop that large and that fast grabbed its attention.

FIGURE 18.2. S&P 500 stock index, December 2019–September 2020.

Source: S&P Dow Jones Indices.

Disruptions in fixed-income markets were also happening at the time, and they got even more of the Fed’s attention. Figure 18.3, which displays an index of the interest rates on junk bonds, shows one extreme example.⁶ That index soared from under 4 percent to almost 11 percent over the same period in which the stock market cratered. Figure 18.4 exhibits a less extreme example: the spread between Baa-rated corporate bonds and ten-year treasuries, which rose by about 425 basis points over that same period.

FIGURE 18.3. Interest rate on junk bonds, index, December 2019–May 2020.

(ICE BofA U.S. high yield index option-adjusted spread.)

Source: ICE Data Indices, LLC.

FIGURE 18.4. Interest rate spread between Baa corporate bonds and U.S. treasuries, December 2019–May 2020.

(Moody’s seasoned Baa corporate bond yield relative to yield on ten-year Treasury constant maturity.)

Source: Federal Reserve Bank of St. Louis.

There was even, amazingly and disconcertingly, a severe hiccup in the Treasury markets in March. Yields on T-bills actually dipped below zero for a frightening few days as traders scrambled for liquidity that securities dealers could not provide. And it wasn’t just T-bills; rates on longer-maturity treasuries also gyrated wildly for a short time. The Fed was now witnessing disruptions right in its own backyard and jumped in to soothe the markets. That meant providing liquidity to meet the “dash for cash” and eventually creating a standing loan facility to ensure that the repo market wouldn’t crash again.

First Responders: Lending Facilities

Close inspection of these last three graphs reveals that all three markets hit bottom on March 23, 2020, and then started to improve rapidly. That was no coincidence. At 8 A.M. that day, following yet another unscheduled meeting (FOMC 2020b), the FOMC announced that “the Federal Reserve is committed to use its full range of tools to support the U.S. economy in this challenging time.” More specifically, “The Federal Open Market Committee is taking further actions to support the flow of credit to households and businesses by addressing strains in the markets for Treasury securities and agency mortgage-backed securities,” continuing “to purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning,” and continuing “to offer large-scale overnight and term repurchase agreement operations.” It also pledged to take “additional measures to support the flow of credit to households and businesses” (FOMC 2020b). In short, the Fed was all in.

The central bank’s virtually open-ended commitment to backstop most forms of credit served as a powerful tonic to the financial markets, which were teetering at the time and looking for a lifeline. The markets’ quick reactions were redolent of what had happened in European sovereign debt markets in July 2012 when European Central Bank president Mario Draghi made his famous “whatever it takes” pledge (Draghi 2012). The words—Draghi’s then, the Fed’s now—were galvanizing and stopped the incipient financial panic in its tracks. In Draghi’s case, the European Central Bank never had to back up his words with a single euro. In the case of the Fed’s announcement on March 23 the market reactions came swiftly, long before the central bank committed a dime, and the eventual volume of Federal Reserve lending, though sizable, turned out to be minimal relative to the enormity of the problem. Words matter, especially if they are credible and backed by mountains of cash.⁷

Although the whole process unfolded quickly, it is useful to think of the Fed’s emergency lending facilities as coming in two tranches. First, the central bank reinstated several of the facilities it had created during the financial crisis of 2008–2009 but had let lapse when they were no longer needed. These arrangements, justified by Section 13(3) of the Federal Reserve Act (as amended by Dodd-Frank in 2010), concentrated on stabilizing the money markets, including the commercial paper market,⁸ but they also reprised the Term Asset-Backed Securities Loan Facility to support the issuance of asset-backed securities backed by student loans, auto loans, credit card loans, Small Business Administration loans, and the like.

The Fed didn’t stop there, however. Its legal and accounting staffs must have worked overtime to create two new facilities to support the corporate bond market,⁹ one to support the municipal bond market,¹⁰ and two more to assist banks in lending to Main Street businesses (as opposed to Wall Street firms).¹¹ All of these new lending facilities, especially the last two, meant that the Federal Reserve was venturing into places it had never gone before and about which it had little or no relevant experience. Yet the central bank stood up all these facilities in about three weeks. That was not exactly typical central bank speed.

Speed was one thing; scope was another. Supporting the corporate bond market, whether doing so when bonds are originally issued or later in the secondary market, was something the Fed had never attempted during the 2008–2009 financial crisis. But it was at least on relatively familiar turf there, dealing in large-denomination bonds carrying high credit ratings.¹²

The Municipal Liquidity Facility (MLF) was a bird of a different feather. While the Federal Reserve Act explicitly allows the FOMC to conduct open-market operations in municipal debt, it restricts the scope to instruments with maturities “not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues” (Federal Reserve Act 1913, sect. 14). The MLF was designed to be much broader and longer-term than that, so it was structured as an emergency lending facility under Section 13(3) rather than as open-market operations. (The Fed had used this legal fig leaf extensively in 2008 and 2009.) The special purpose vehicle created for that purpose was capitalized by $35 billion from the U.S. Treasury and authorized to purchase up to $500 billion in municipal obligations (broadly defined). It was barely used, however. The cash-strapped state of Illinois was first in line, eventually taking out several loans, but the line proved to be short. At their peak in early 2021, the MLF’s total outstanding loans were a mere $6.4 billion. Apparently, the availability of the Fed as a backstop, starting with the dramatic March 23, 2020, pronouncement, was enough to calm the municipal bond markets, making actual MLF lending almost superfluous. Shades of Draghi.

The Main Street Lending Program (MSLP) was an even bigger departure from Fed norms. The idea behind it was (in the Fed’s words) “to support lending to small and medium-sized for-profit businesses and nonprofit organizations that were in sound financial condition before the onset of the COVID-19 pandemic” (Federal Reserve 2022). More specifically, MSLP loans under Section 13(3) were targeted at businesses too small to issue corporate bonds but too large for the PPP. To put it mildly, such businesses were not even on the Fed’s radar screen before the crisis. Like most central banks, the Fed had plenty of experience with large-dollar loans to financial businesses but basically none with small-dollar loans to nonfinancial businesses.

Lacking the experience and resources relevant to that sort of lending but mandated by the CARES Act (March 2020) to do so, the Fed had to scramble. Naturally, it turned to commercial banks to originate the loans, insisting that the banks retain 5 percent of each loan. The Fed would then buy the other 95 percent. The MSLP’s lending volume was budgeted as high as $600 billion, with the Treasury providing $75 billion in equity to capitalize the special purpose vehicle the Fed created for this purpose.

To put it bluntly, the MSLP was a failure, just as many observers predicted when it was first announced. The Fed’s initial term sheet (April 2020) invited banks to sell loan participations ranging from $500,000 to $25 million from loans made to companies employing up to ten thousand workers or with revenues of less than $2.5 billion. Those are “Main Street” businesses? The lower loan limit of $500,000 was subsequently reduced to $100,000. Yet take-up was still modest. Many banks were less than delighted by the requirement that they retain 5 percent of each loan, many businesses found the Fed’s terms less than attractive, and not many Main Street businesses wanted to borrow $500,000. The MSLP was terminated by the Treasury in the closing days of the Trump administration. At the time, outstanding MSLP loans were a mere $16.5 billion. Could MSLP lending have been made to work better? Almost certainly, yes. But the Fed was the wrong agency to do it.

The Paycheck Protection Program Liquidity Facility (PPPLF), another strange venture for the Fed, grew much larger and lasted much longer (until July 2021). The PPP itself was an important component of the mammoth CARES Act that Congress passed in late March 2020. Its animating idea was to offer small businesses forgivable loans—implicitly, grants—so they could continue paying their workers through what Congress then thought would be a short interruption. As it turned out, the interruption wasn’t short at all. So, Congress boosted the size of the program and extended its expiration date several times.

The Fed’s involvement in PPP came because the law authorized the twelve Federal Reserve Banks to provide nonrecourse loans to financial institutions (mainly banks) that made PPP loans to eligible businesses. Notice the two important adjectives: nonrecourse loans to banks backed by forgivable loans to bank customers. That sounds like a sure-fire recipe for large losses. Everyone realized that, of course, and rather than make a hash of Bagehot’s dictum (explained in chapter 13), PPP loans were fully guaranteed by the Small Business Administration, making them perfect collateral for the Fed. If the place where loan losses were booked mattered to you—and it certainly mattered to the Fed—the Small Business Administration guarantee took them off the Fed’s books.

Unlike the Main Street and municipal facilities, the take-up of the PPP program, and thus of the PPPLF, was enthusiastic and swift. The PPPLF was launched on April 16, 2020, and within three weeks it had lent out almost $30 billion. The sums kept climbing from there, requiring several replenishments by Congress. By November 2021, the PPP had made over 11 million loans totaling nearly $800 billion, of which over $600 billion had already been forgiven (figure 18.5). The Fed’s backup commitments, of course, were far smaller. When it closed out its program in July 2021, the PPPLF held about $61 billion. Even so, that was almost triple the sum of all Federal Reserve lending under the municipal and Main Street facilities.

Lest anyone miss the point, Federal Reserve Chair Jerome Powell repeatedly stated that in all these unorthodox operations, the Fed was “lending, not spending.” It became his mantra. And, of course, all this lending activity was dwarfed by the Fed’s pandemic-induced QE asset purchases, which eventually topped $4 trillion.

The lending facilities were all temporary, of course, designed to cope with an emergency. But Powell did not stop there. In August 2020, he led the FOMC in adopting the biggest changes in its monetary policy procedures in decades. Four aspects of those changes stand out.

First and foremost under the harrowing circumstances, the Fed changed the operational weights on the two parts of its dual mandate, making clear that it would prioritize reducing unemployment and that the mandate for a strong labor market would be interpreted broadly—not limited to the official unemployment rate.

FIGURE 18.5. Cumulative lending by the Paycheck Protection Program, monthly, March 2020–June 2021.

Source: Small Business Administration. Calculations courtesy of Robert Jackman (Faulkender, Jackman, and Miran 2022).

Second, the Fed made the employment objective explicitly asymmetric; the FOMC cared much more about employment that was too low than about employment that was too high.

Third, in recognition of the disappearance of a reliable Phillips curve, the FOMC stated that it would not take preemptive action (based on a forecast) against inflation but would wait until it saw inflation rising.

Fourth, the Fed replaced its 2 percent inflation target by something it dubbed “Flexible Average Inflation Targeting,” an intellectual cousin of price-level targeting. The message was that the Fed would no longer strive for 2 percent inflation every year but would instead seek to make inflation average 2 percent “over time,” a deliberately vague phrase that did not specify the length of the averaging period or its starting and ending points. Amazingly, even as inflation skyrocketed in 2021, few Fed watchers paid much attention to the inflation averaging period, which was never specified. Flexible indeed!

“Some have greatness thrust upon them.”¹³

When Jerome “Jay” Powell took over the reins of the Federal Reserve from Janet Yellen in 2018, things looked peaceful on the monetary policy front. Yellen had begun to normalize interest rates from their financial crisis lows, and there seemed to be no good reason to deviate from her script. Then COVID-19 struck and changed everything, including monetary policy. The Yellen script became useless, with nothing obvious to replace it. The way Jay Powell rose to the occasion assures his place in history.

Powell was born in Washington, D.C., one of six children. His father, also Jerome Powell, was a lawyer, which is how his son began his career. The younger Powell graduated from Princeton University and then from the Georgetown University law school. While there, he was editor in chief of the Georgetown Law Journal. Obviously he was a promising young lawyer, but not for long.

In 1984 Powell switched from law to investment banking, where he remained more or less for twenty-six years. That period included time out for a brief stint at the U.S. Treasury under George H. W. Bush in 1992–1993. Between 2010 and 2012, Powell was a visiting scholar at the Bipartisan Policy Center, a Washington think tank, where he worked on predicting and minimizing the damage from hitting the national debt ceiling.

In December 2011, President Barack Obama paired Powell with Jeremy Stein, a Harvard professor and a Democrat, in order to get two nominees to the Federal Reserve Board through a recalcitrant Senate. Obama’s strategy worked but, in the view of some, set a terrible precedent; it was as if the board had “Democratic” and “Republican” seats.

On the job, Powell proved himself to be political only in the good senses of that term. He spoke regularly with members of Congress of both parties, he understood that the Federal Reserve and Congress operate in separate “lanes” (a favorite metaphor of his), and he staunchly defended the Fed’s independence. In 2018, when President Trump decided that he would not reappoint Democrat Janet Yellen as Fed chair, he turned to Powell, a registered Republican though certainly not a Trump Republican. The Trump-Powell relationship soon soured, as recounted in chapter 17. Powell stood his ground as the FOMC nudged interest rates slowly upward.

Then COVID-19 hit, requiring unprecedented actions from the Fed beginning in March 2020. Soon Powell was looking and behaving like the most dovish Fed chair in history, leading the central bank, among other things, to the major changes in its operating procedures discussed in this chapter. As events unfolded, the Fed emphasized the need to improve weak labor markets. Until December 2021, it regularly branded the sharp increases in inflation as “transitory.” All in all, this did not look like Volcker redux.

President Biden Ups the Ante

The atmosphere was tense as Joseph R. Biden was sworn in as the forty-sixth president of the United States on January 20, 2021. The defeated Donald Trump was still wailing that the election had been stolen from him, and his acolytes had stormed the Capitol only two weeks before. As president-elect, Biden had stated emphatically that the $900 billion relief package passed in the closing days of the Trump administration was not nearly enough, and in the early days of his administration a combination of events enabled him to do much more. The most important of these events were the Senate runoff victories in Georgia mentioned earlier. They installed Raphael Warnock and Jon Ossoff as two new Democratic senators, thereby producing a 50–50 tie in the Senate. If needed, the tie-breaking vote could now come from Vice President Kamala Harris, acting in her capacity as president of the Senate.

The second important ingredient propelling Biden’s early success was the Senate’s arcane budget “reconciliation” procedure, which was familiar to the cognoscenti but almost unknown outside the beltway. Reconciliation is governed by a special set of rules that allow the annual budget to pass the Senate with just fifty-one votes rather than the sixty votes needed to overcome a filibuster. In plain if oversimplified English, the minority party may not filibuster the budget, which in this case opened the door to a COVID relief bill voted in only by Democrats.

Thus armed for battle, President-elect Biden surprised many observers, including many of his supporters, when he proposed his mammoth $1.9 trillion American Rescue Plan six days before his inauguration. The ARPs gigantic price tag, including its huge dollop of money for state and local governments ($350 billion), was probably enough to ensure that no Republicans would support the bill. But Biden, apparently thinking about passing the bill with only fifty votes anyway, threw in several more items that were anathema to Republicans, such as an increase in the federal minimum wage to $15 an hour (which was later dropped) and a huge increase in the child tax credit, including making it refundable. He also included $1,400 tax “rebate” checks, thereby bringing the $600 bipartisan number enacted in December 2020 up to the $2,000 figure that Trump had favored (but congressional Republicans had not).

At the end of a relatively short debate, the ARP passed the Senate 51–50, with every Republican voting no, and then passed the House by 220–211, with every Republican again voting no. Bipartisan support for COVID relief packages was plainly a thing of the past. The attitude of House minority leader Kevin McCarthy (R-CA) captured the Republican Party’s hostility: “This isn’t a rescue bill. It isn’t a relief bill. It’s a laundry list of left-wing priorities that predate the pandemic and do not meet the needs of American families” (Cochrane 2021).

The bill’s critics did not come exclusively from the political Right, however. Former treasury secretary (under Bill Clinton) Lawrence Summers caused a stir with a February 4, 2021, op-ed in the Washington Post warning that adding $1.9 trillion of further stimulus to the $0.9 trillion that had just been enacted was probably too much. It would, Summers said, likely lead to an overshoot of potential GDP and possibly to “inflation pressures of a kind we have not seen in a generation” (Summers 2021). That criticism, which subsequently looked prophetic, raised eyebrows and provided fodder for Republicans, basically all of whom were opposing the bill. It did not, however, persuade any Democratic legislators. Still, Summers’s central point was worth noting: $2.8 trillion in additional spending was more than a quarter larger than the landmark CARES Act. Even though many ARP programs had “low multipliers,” a lot of stimulus would be put in the hopper.

Was There an Inflationary Danger?

In March 2021, the month the ARP passed, some nervousness developed in the bond market. It was hardly surprising. After all, the Federal Reserve’s near-zero interest rate policy and its rapid balance sheet expansion policy were proceeding apace even as massive fiscal stimulus was coming on line. The ten-year Treasury bond rate, which had fallen to barely above 50 basis points during the worst of the pandemic’s financial panic, began climbing in August 2020. And that climb accelerated in the early months of 2021, from about 1 percent in late January 2021 to about 1.7 percent by late March (after which it leveled off and even declined a bit). Even at 1.7 percent, however, the level of the long rate could not be called high in any meaningful sense; after all, the Fed had loudly and frequently proclaimed its desire to return inflation to 2 percent, which would make a 1.7 percent nominal bond rate negative in real terms. But the speed of the climb attracted attention and, in some quarters, worries.

It was not hard to think of reasons why bond rates might have risen. After all, the economy was plainly on the mend, with strong growth anticipated for 2021. (That strong growth subsequently materialized.) As just mentioned, large amounts of fiscal stimulus were coming online, where they would join what looked to be sizable pent-up demand from consumers who had been more or less forced to save an inordinate share of their incomes. On top of all this, the Fed was continuing its supereasy monetary policies. Conventional macroeconomic thinking could certainly lead to the conclusion that inflation from excess demand was on the way, as Summers and others fretted.

On the other hand, however, many economists remembered that the once-reliable Phillips curve had apparently died a mysterious death two decades earlier, as mentioned at the end of chapter 3. Just before the pandemic struck, the U.S. economy had enjoyed an unemployment rate near 3.5 percent for six months and at or below 4 percent for nearly two years, all without the slightest sign that inflation was perking up. It would be a long time before the United States got back to 3.5 percent unemployment. Even when the bond market was getting agitated about inflation in late March 2021, the break-even inflation rate implied by the Treasury Inflation-Protected Securities (TIPS) market stood at only around 2.25 percent, which was almost exactly the Fed’s long-run inflation target.¹⁴ If inflationary alarm bells were sounding, they certainly were not loud.

Then the inflation picture began to change. The early months of the pandemic had beaten the monthly inflation numbers for February–May 2020 down into negative territory. But in February–May 2021 as these aberrant months were replaced by 2021 figures in the twelve-month average, measured inflation was destined to rise—which it did, though quite a bit more than expected. The Consumer Price Index inflation rate, for example, soared at an annualized 7.4 percent pace over the January–May 2021 period, compared to −3.1 percent over January–May 2020. That alone boosted the headline-making twelve-month inflation rate to 5 percent, which got some alarmists talking about a return to the inflation of the 1970s and early 1980s. As spring gave way to summer, fall, and then finally winter, inflation crept even higher. Apparently, however, few of those inflation alarmists were bond traders. Both ten-year Treasury rates and ten-year breakeven rates on TIPS rose only modestly.

The big controversy of the day was over whether these high inflation rates were transitory—a joint product of the data rotation just mentioned and various shortages and bottlenecks from reopening—or something more lasting. The bond market and most of the FOMC, prominently including Chair Powell, were firmly in the transitory camp. For example, the FOMC “Summary of Economic Projections” issued in June 2021 projected a personal consumption expenditure (PCE) inflation rate of only 2.1 percent in 2022. And so, certainly, was the White House. But a few FOMC members were getting nervous about prospective inflation, and Summers and others continued to sound the alarm. As high inflation numbers accumulated over the summer and fall of 2021, inflation worries grew. Was all this really transitory?

On November 3, 2021, the FOMC announced its intention to begin tapering its asset purchases over the coming months (FOMC 2021). (Remember, as long as it was engaging in QE purchases, the Fed was tapping on the accelerator, not the brake.) But this time, unlike in 2013, the markets reacted calmly; there was no taper tantrum. After all, the Fed had all but announced its decision prior to issuing the official word, and everyone could see that the economy was growing strongly and that inflation was too high. By the end of November, Chair Powell made it clear in congressional testimony that the FOMC would accelerate the taper. He also jettisoned the word “transitory” when referring to the rise in inflation, saying “it’s probably a good time to retire that word and explain more clearly what we mean” (Timiraos and Omeokwe 2021). As 2021 drew to a close, markets expected an end to tapering by March 2022, with interest rate liftoff following shortly thereafter. (Both of those did indeed happen.) That said, the specter of yet another COVID variant—this one labeled “omicron”—was casting a shadow of uncertainty over the recovery. Infections soared to record heights, but the economy soldiered on.

Building Back Better

Meanwhile, the two makers of fiscal policy—the White House and the Congress—were engaged in pitched battle yet again. In addition to the ARP, President Biden had proposed an American Jobs Plan and an American Families Plan, each in the $2 trillion range over ten years and each financed mainly by higher taxes, especially on the rich and on corporations. Republicans in Congress were appalled by the gigantic expansion of government, basically unsympathetic to Biden’s list of public “needs” (except for physical infrastructure), and adamant about not raising taxes.

Since Democrats held only a slender majority in the House and the Senate was evenly split, Biden could push legislation through Congress only if he held on to every Democratic senator and used reconciliation to avoid filibusters. On top of all that, Senator Joe Manchin (D-WV), after providing one of the fifty votes for the ARP, insisted on bipartisanship thereafter. That attitude essentially handed a veto pen to Senate minority leader Mitch McConnell, who was only too happy to wield it.

Part of the Republican strategy was to separate the physical infrastructure provisions from the rest of the Biden package. And indeed, in July 2021 a fragile bipartisan agreement emerged on physical infrastructure and passed the Senate. The House, however, delayed passage until November, wanting to pair the infrastructure bill with the much larger package of social, educational, and climate measures that combined elements of Biden’s American Jobs Plan and American Families Plan. The House passed that second bill, now dubbed “Build Back Better,” on a strictly partisan vote on November 19. But the Senate proved a tougher nut to crack, and as 2021 drew to a close, Build Back Better looked dead (which it was).

Chapter Summary

COVID-19 hit the U.S. economy and indeed all the world’s economies hard, leading to a terrifying recession in 2020 that, while short, was far from sweet. Large monetary and fiscal responses were clearly imperative. But they had very different targets.

Fiscal policies delivered cash relief, largely through tax cuts and transfer payments, to those who lost their jobs, those who lost their incomes, businesses threatened with oblivion, and so on. The combined fiscal effort under the Trump and Biden administrations added up to about $6 trillion, an enormous sum even for the gigantic U.S. economy.

In the Washington budget argot, almost none of this was “paid for.” So, the already-large federal budget deficit soared to levels not seen since World War II. But nobody in Washington seemed to care. Neither did the bond market; interest rates remained low. In its early stages, the fiscal expansion was strongly bipartisan; in its later stages, it turned bitterly partisan.

Monetary policy was hampered a bit by starting the crisis period with a very low federal funds rate, which it quickly dropped to near zero. So, the Fed concentrated on holding the shaky financial system together via both reassuring talk and the rapid creation of a large number of liquidity facilities. Bagehot on steroids, one journalist called it (Timiraos 2022, chap. 10).

Central bank independence was both maintained and forgotten during the crisis. On the one hand, President Trump stopped berating the Fed when the central bank turned to cutting rates instead of raising them. And President Biden reverted to the status quo ante, enabling the Fed to decide matters independently. On the other hand, however, central bank independence melted away as it had in 2008, as the Treasury and the Fed worked together to stand up several liquidity facilities, often with the Treasury offering backstop funding in case the facility suffered losses. As Fed Chair Powell was fond of saying, the central bank was “lending, not spending.”

Initially, the steep recession and the accompanying fears that things would get worse drove inflation down from about 2.5 percent in the twelve months ending January 2020 to a low barely above zero in the twelve months ending May 2020. But the recovery was V-shaped, and high and rising inflation became the big macroeconomic story of 2021 and 2022. The twelve-month inflation rate soared from 1.7 percent in February 2021 to 6.9 percent in November 2021, the highest since the early 1980s. Then, in early 2022, it went even higher.

At the Fed, Powell and Company took their feet off the proverbial accelerator by tapering QE purchases quickly and penciling in several rate hikes for 2022. But neither monetary nor fiscal policy could do much to alleviate the unconventional problems with supply chains, which were unable to keep up with burgeoning demand for things that come in boxes. That unusual problem, unfixable by either fiscal or monetary means, grew even worse when Russia invaded Ukraine in March 2022.

______________

1. It was later learned that several COVID deaths had occurred earlier in California.

2. Quarterly data follow the calendar, but the worst three months were actually March, April, and May.

3. See, for example, Goolsbee and Syverson (2021) and Gupta, Simon, and Wing (2020).

4. Just as it had in 2008–2009, the Fed steadfastly refused to lower the funds rate below the 0–0.25 percent range even though many other central banks had moved their overnight rates into negative territory.

5. By comparison, it took more than five years for the S&P to gain back its fall 2008 losses from the financial crisis.

6. The index is compiled by the Bank of America, which says it “tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market.” It is available on the St. Louis Fed’s FRED database (Ice Data Indices 2022).

7. The Fed did, however, start buying enormous quantities of treasuries and mortgage-based securities as QE.

8. For example, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Money Market Mutual Fund Liquidity Facility.

9. The Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility.

10. The Municipal Liquidity Facility.

11. The PPPLF and the MSLP.

12. Well, not all the ratings were high. At one point the Fed decided to support “fallen angels” in the secondary market, that is, formerly investment-grade issues that had been downgraded to high yield status by the rating agencies.

13. The quote is from Shakespeare, Twelfth Night, Act 2, Scene 5. The bard presumably knew nothing about monetary policy.

14. The Fed posts a target for the PCE deflator, not for the Consumer Price Index. Inflation measured by the PCE deflator tends to run about 20–40 basis points below inflation measured by the Consumer Price Index.