Treasury Secretary and Fed Chair Testify Before Congress on Pandemic Economy

By:
Chris Gaetano
Published Date:
May 20, 2020
Treasury Secretary Steven Mnuchin and Federal Reserve Chair Jerome Powell testified before the Senate Banking Committee yesterday, answering lawmakers' questions about the economy in the time of COVID-19.

More Pain to Come

Both Mnuchin and Powell, at various points in the hearing, expressed concern that the economy risks long-term damage if current conditions continue, particularly in terms of unemployment.

Powell noted, for instance, that "long periods of unemployment can really affect people’s ability to go back to work, because they lose their networks, they lose their skills, they lose contact with the job market." He said that "if we allow unnecessary avoidable insolvencies because of effectively a natural disaster, that too will destroy the work of many families and generations, and it’ll weigh on the economy."  While he praised Congress' fast action in response, he said it remains to be seen whether this will be enough.

Mnuchin, for his part, struck a slightly more optimistic tone, saying that he expects the economy to improve in the second half of the year. That being said, he still cautioned that "I think the job numbers will get worse before they get better" and that people should understand that the country will be going through "a very difficult quarter."

Municipal Bond Support

Senators also had a number of questions about the Federal Reserve's credit facility that will buy municipal bonds in order to support state and local governments, which Mnuchin said he expects to be up around early June .

For example, Committee Chair Sen. Mike Crapo (R-Idaho) noted that, under the term sheet, many smaller cities and counties would not be eligible for this facility. Powell noted that while the Fed previously decided to expand access to smaller communities, with over 50,000 entities capable of borrowing, "we need to draw some lines to be able to handle this." However, he said that in the case of these smaller communities, "we will always be willing to lend to a state, with the purpose of downstreaming to counties, cities, other subdivisions of government authority within the state." He also said that "we're continuing to look at ways to accommodate further borrowers, including perhaps in the case of states with relatively low populations, where the only borrower with access may be the state government itself."

This played into larger concerns that some senators expressed regarding how poorly state and local government entities were doing in the pandemic economy. Sen. Jack Reed (D-R.I.) noted that there are 20 million jobs in state and local governments that, combined, make up 8.5 percent of national GDP. He also noted that these entities are projected to suffer budget losses of between 10 and 25 percent. 

Sen. John Kennedy (R -La.) pointed out, however, that many state constitutions might make the Fed's assistance problematic. Nearly all states have measures that prohibit them from borrowing money to operate their government, although they can borrow to create infrastructure, such as roads. He wondered how the central bank could navigate this issue.

Powell, in response, said that despite these constitutional measures, most states "could borrow, during the course of a year, for maturities of less than a year to smooth out the inflow of cash, revenue anticipation notes [and] tax notes." Further, if there were a legal prohibition on using the Fed's credit facilities, the governments certainly have not brought it up, as he confirmed they have received a lot of inquiries about the program.

Taxpayer Dollars at Risk

With the large amounts of money being lent through the government, senators also expressed concern about the potential for losses. Mnuchin acknowledged that there are a lot of questions as to whether the government is willing to take risks with these loans, and potentially losses, and, he said, "I would say the answer is absolutely, yes." He noted that, in the case of the Fed's lending facilities, "any facility that the Fed believes puts them at risk, I do put up capital. So by definition, that capital is at risk, and we are fully prepared to take losses in certain scenarios on that capital."

But, at the same time, he noted that just the announcement that the Fed was going to be propping up the corporate debt market, "without putting up $1 of taxpayer money, unlocked the entire primary and secondary market for corporate bonds," which meant companies that previously might have needed to access the Fed facility were able to borrow through other means. With this in mind, Mnuchin said, "in the best case scenario, the markets open up and we don't need to use these facilities."

Powell, too, acknowledged risks, particularly where it concerns the Fed's decision to directly lend to businesses. He conceded that this is something that the Fed has never done before, and it might take some time for the central bank to find its feet in this area, but he added that the Fed has brought on experts to ensure the process is at least somewhat safer.

"Main Street is in a class by itself, really. It's not the bond market, right? These are small and medium-sized companies. They live in a world of bank lending. That's a world of negotiated documents and we're trying to enter that world and make loans to qualifying buyers," he said. "So we've set up operations at the Federal Reserve Bank of Boston
and hired service providers. And we’re doing all of that to be ready to face off against it. It’s very diverse—small, medium, and large companies, very different industries with very different credit needs. Some of them asset-based, some of them cash flow-based. So it’s a really complex undertaking, and people are working literally around the clock and have been for weeks to get it ready by the end of this month."

Despite these preparations, Mnuchin said that even in a best-case scenario, he expects that the government will lose money on these loans, although he noted that this is no different than the expectations with the Troubled Asset Relief Program in the last financial crisis, in that the Treasury Department never expected to come away with a net gain. In fact, he said, while Treasury's analysis includes a scenario where "the world gets better and we actually make a small amount of money," Treasury has also prepared scenarios "within Main Street where we could lose all of our capital, and we're prepared to do that."

Powell said that the Federal Reserve is trying to mitigate at least some risk by setting the penalty rate slightly higher than the normal rate, but still below what the market is providing, which, he said, "encourages prompt repayment. It helps those who can’t get credit, but not those who want credit from us to save a few basis points. And if markets are functioning reasonably well, we don’t want to replace them. We we want to be a backstop to those."

But Sen. Chris Van Hollen (D-Md.) was still worried about the credit risks that the Fed was exposing itself, and by extension the U.S economy, to. He noted that, under the central bank's new borrowing facilities, it will begin directly buying junk bonds off the secondary market.

"It puts the public in a first-loss position behind even the most subordinated bond holder and uses public funds that take on years and even decades of the future cash flows with the price risk," he said.

Powell noted that the only junk bonds the Fed is buying are those from firms that were formerly investment-grade before being downgraded in the crisis, also known as "fallen angels." He said they didn't want there to be "a cliff there to where the investment grade markets are working well, but the leverage markets or non-investment grade markets are not."

Van Hollen, however, remained unconvinced, saying that "a lot of those bonds were already in trouble before the intervention, and their trouble was not directly related to the pandemic."

Jobs

The hearing also included an exchange between Mnuchin and Sen. Elizabeth Warren (D-Mass.), who noted that the Fed's new loan facility does not strictly require that the funds be used to keep people in their jobs, which she said would be an important part of an eventual economic recovery. She asked, repeatedly, whether the Treasury would impose a requirement that any loan recipients keep people on the payroll.

Mnuchin answered that the number one objective is keeping people employed, and that the loans will have a number of "very significant" restrictions on matters such as employee compensation, dividends and buybacks. In the Main Street facility, in particular, he said the loans come with an expectation that people "use their best efforts to support jobs."

But Warren said this was insufficient, observing that it would be easy for companies to skirt this expectation since it is so vague, and she excoriated the secretary for not putting in such a requirement. Mnuchin, for his part, said that the terms had been determined in bpartisan talks and agreed to by both parties.

Sen. Brian Schatz (D-Hawaii) noted that even when the rules say companies must maintain payroll, companies still seem to be doing the opposite. He said that while the CARES Act states that air carriers receiving payroll grants must refrain from conducting involuntary furloughs or reducing pay rates and benefits, grant recipients have done so anyway. He noted, for instance, that United Airlines received $4.9 billion on April 21, and then on May 1 announced it would move 28,000 workers from full time to part time.

Mnuchin said that he believes the company is now in compliance with the program. When asked whether this means that  it wasn't in compliance before, the secretary demurred, saying he didn't want to get into specific situations with specific companies, but repeated that, "right now we believe they are in compliance with the agreement."

Exit Strategy

Sen. David Perdue (R-Ga.) said he understood why the Federal Reserve was purchasing so much debt, but he expressed concern about how the country will ultimately "put the genie back in the bottle."

Powell said that, as the assets the Fed bought mature, "over time, and that time will probably not be very soon, but over time, the assets that we have on our balance sheet from this era will come to maturity. They'll roll off. And the balance sheet will, again, very gradually, return. This'll be some years down the road, I would think."

Looking at the size of the balance sheet unto itself, said Powell, was looking at the wrong thing anyway. What's important, he said, was the size of the balance sheet relative to the size of the economy. He noted that, just by holding the balance sheet constant from 2014 to 2017 and letting assets mature, "we came down from, what, 25 percent of GDP to 16 or 17 percent of GDP. So it can be done over time."

He also noted that the Fed's assets do not raise inflation or financial stability concerns for him.

Meanwhile, in response to concerns about the huge amounts of money the government has been borrowing to finance the CARES Act and other aid measures, Mnuchin said that lower interest rates and bond maturities will go a long way in controlling debt costs over the long run.

"It is my intention ... to borrow money in the short term to have the funding, but then to expand out financing in 10, 20 30 year bonds," he said. "What I'd like to do is lock in a significant amount at very low interest rates so that the money we're borrowing can be paid back and dealt with over a long period of time."

Click here to see more of the latest news from the NYSSCPA.