Fed Should Buy Munis Now to Combat Coronavirus

(Bloomberg Opinion) -- Almost 11 months ago to the day, I brainstormed about what sorts of unprecedented steps the Federal Reserve might take when the next hypothetical recession came knocking.

Obviously, the U.S. economic situation has changed drastically since then. Because of the coronavirus outbreak, it’s looking increasingly likely that the country — and possibly the world — is headed for a short downturn at best and a full-blown recession at worst. The Fed emptied the vast majority of its toolkit on Sunday when it slashed its benchmark lending rate by 100 basis points to near zero and pledged to buy at least $500 billion of Treasuries and $200 billion of mortgage-backed securities in the coming months.

The potential solution I came up with for the Fed to go further is only more relevant today. In fact, it could actually be a specific answer to the coronavirus and how government officials are grappling with the tough decision to effectively force Americans to grind their lives to a halt. My proposal: The Fed should step into the $3.8 trillion municipal-bond market to give states a much-needed lifeline. Citigroup Inc. strategists hopped aboard this train of thought on Monday as well, advocating for the Fed to include munis in its quantitative easing program.

Here’s what I wrote in April 2019:

As the Federal Reserve contemplates what the next recession might look like, and what tools it has available to combat it, the fiscal health of U.S. states is likely to emerge as a significant roadblock to any economic recovery. Unlike the federal government, states can’t rely on running persistent budget deficits during a downturn, nor can they rapidly add workers to their payrolls. That means either sharp cutbacks in public services, higher taxes or shortchanging pensions. None of those options will stimulate growth.

The central bank can only do so much during a downturn to get companies and individuals to borrow. But by directly backing states, it will immediately allow them to make payroll, start on new infrastructure projects, or both.

Cities across the U.S. are limiting restaurants and bars to takeout and delivery and closing movie theaters and concert venues. A crunch in the industries more jeopardized by the coronavirus threatens state and local government budgets, which rely in no small part on taxes from hotels and restaurants to cover expenditures. New York City Comptroller Scott Stringer warned on Monday that the largest U.S. city faces the possibility of “a prolonged recession” and could lose $3.2 billion in tax revenue over the next six months.

Well, the Fed just so happens to already have the authority to buy municipal debt with maturities of up to six months. So while I envisioned Congress expanding the central bank’s authority to buy longer-term securities (a tall order given the Washington gridlock), skipping that step is hardly a deal-breaker. Its current powers might just be enough.

Skanda Amarnath at Employ America and Yakov Feygin at the Berggruen Institute pointed this out in a recent Medium post. To them, this sort of muni financing would work similarly to the Commercial Paper Funding Facility, which the Fed created in October 2008 to buy what are effectively short-term IOUs from corporate issuers and restore confidence in the market. The central bank may yet restart the program and intervene, given that the commercial paper market is seizing up again, but that doesn’t mean it shouldn’t extend the offer to strapped localities as well.

Here’s Amarnath and Feygin:

“The CPFF’s successful provision of liquidity to businesses in the GFC makes it a model for establishing a short term, emergency muni funding facility. A short-term funding facility will allow state governments to ride out the COVID-19 pandemic and its associated market dysfunctions. Market turbulence did not begin with muni markets, but it now seems to be having a uniformly constraining effect across all issuers, regardless of their underlying financial health. Sales tax collections and other state-level revenue generators are likely to decline for virtually all governments as economic activity takes a hit. Without the same degree of working capital or stable lines of credit that are typically available to private sector entities, state governments are more likely to be forced into making sharp expenditure cuts if financial markets freeze up for a sustained period.”

They suggest the Fed make the facility available for at least 12 months after the coronavirus damage to the U.S. economy reaches its peak, allowing state governments to easily roll over debt at a predictable price.

This makes a lot of sense. It’s possible, but far from certain, that the muni market will settle down in the coming weeks after its worst rout since 1987. As it now stands, triple-A rated munis maturing in three and six months yield 1.2%, according to Bloomberg Valuation data. That compares with 0.2% and 0.28%, respectively, for similar maturity U.S. Treasuries. The gap is only wider for those without pristine credit grades.

A percentage point or two might seem small, but every little bit counts for states and cities. Governments will have to lay off employees or cut back public services to offset lost tax revenue or to cover any additional resources provided to local health authorities. And that’s to say nothing of public pension plans, which were underfunded by trillions of dollars even before U.S. equities fell into a bear market and long-term bond yields reached record lows.

The coronavirus outbreak has already demonstrated the importance of state and local leadership when there’s a lack of it from the federal government. The Fed could ensure that states get a fair market rate, close to the zero lower bound, for short-term borrowing. This wouldn’t be a cash bailout but rather a shield from market volatility that threatens to push up the cost to roll over debt or bridge revenue shortfalls. States would have to repay the debt, with a bit of interest, once the worst of the coronavirus shock is behind them.

No one can be certain when the U.S. will reach that point. It’s the reason risk assets tumbled anew on Monday even after the Fed’s huge easing over the weekend. Investors and central bankers are hoping for the best but expecting the worst.

So are state and local governments. Governors and mayors are undertaking measures that are virtually guaranteed to blow a hole in their budgets for the sake of the health and safety of their residents. The Fed should stand alongside them in their efforts.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

For more articles like this, please visit us at bloomberg.com/opinion

Subscribe now to stay ahead with the most trusted business news source.

©2020 Bloomberg L.P.