Since the 2008 financial crisis central banks started looking for innovative tools and measures to help sustain the economy and financial system.

Interest on excess reserves and quantitative easing were among the most effective innovations that helped driving liquidity to the market and push the economic cycle to start again.

The idea that central banks like the Federal Reserve pay interest on Reserves of Depository Institutions was recommended in the 1970s by Milton Friedman.

This proposal was intended to improve monetary policy by making it easier to hit short-term interest rate targets. However, the Fed didn’t have the authority to pay this kind of interest until 2008.

In addition the U.S. Federal Reserve started a quantitative easing program by increasing its balance sheet by over $4 trillion, as it purchased bonds, mortgages, and other assets. This program was mainly intended for banks to lend and invest those reserves in order to stimulate overall economic growth.

The same action was done again on March 2020 when Federal Reserve announced its plan to implement up to $1.5 trillion in asset purchases as an emergency measure to provide liquidity to the U.S. financial system amid the COVID-19 pandemic and the economic lockdown.  

As the federal reserve used almost all of its tools, the fed chair Powel and other fed members are insisting on the importance of fiscal policy and its major role to sustain the economic recovery and the need for another stimulus as the FED doesn’t have much left to do as they have run out most of their monetary policy tools.

However, through our analysis to historical data and the actual situation, we found a new interesting measure that may help driving more liquidity to the economy and tighten the gap between Wall Street and the main street in terms of benefiting from the central bank given liquidity.

In our modern history, since the internet bubble in 2000 followed by the 2008 financial crisis and nowadays  recession caused by the coronavirus pandemic and shutdown of the economy, every time a shock happens in markets the FED intervenes with its available set of tools to help stop the damage and rebuild the economy again.

But in fact, on the other side, the liquidity provided by the Federal Reserve doesn’t fully reach businesses and industries. As shown in the graph below, although massive liquidity injections through QE in 2008 and 2020, commercial and industrial loans decreases sharply and move to negative territory on percentage change from a year ago after short lived increase.

The reason behind that is that as the shock takes place, affected businesses rush to demand loans from their banks. As the demand increases, banks tighten their standards to get loans and make it difficult for business owners to get the money they need to keep running the business and to face the current economic challenges. The result is that much businesses couldn’t have loans which leads to many bankruptcies, high unemployment rates and low growth.

In other words, much of the effort done by the Federal Reserve to provide liquidity is offset by the banks as they tighten standards for loans.   

The negative effect of banks tightening loans standards is widely obvious, as we see in the second graph below, there is a strong negative correlation between loans standards and the S&P 500 annual returns as a benchmark to economic expansion.

Every time a crisis takes place, loans standards tighten, getting liquidity becomes much harder and returns fall as a simple result.    

The idea behind this analysis is to show that central banks should not only intervene with quantity but also should they take care of the quality and make sure that the support they offer to the economy faces no obstacles in the middle of the financial system supply chain.

We think that credit conditions could be another key measure that the FED can add to its monetary policy tool kit to ensure the accomplishment of the expansionary monetary policy goals and help sustain the economic recovery.

One way of doing this is through a legislative framework that gives the Federal Reserve Bank the power to enforce banks to ease loans standards during certain critical circumstances like the actual one and maybe provide some sort of warranties to protect the banking system from any possible imbalances.

By doing so the central bank can ensure a more level of effectiveness in its monetary policy actions through supporting many businesses to continue carry on their businesses.