The Tell: Fiscal policy had double the impact on the municipal bond market in 2020, paper finds


Fiscal interventions in the municipal bond market when the coronavirus pandemic hit in March 2020 had a significantly greater impact than monetary policy moves, a new academic paper finds.

The paper, from a group of Chicago Federal Reserve researchers, is a reminder of the shocks that rippled through financial markets as COVID-19 lockdowns began. Investors cashed out of muni-bond funds

so aggressively that muni securities were pricing at “fire-sale” levels, the researchers write, pushing prices so low that there was a 450 basis point difference between municipals and Treasuries. No new municipal bonds were issued for several weeks. 

Earlier coverage: As the Fed steps into the municipal bond market, will it be enough?

The federal government responded quickly. On March 27, the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed, making over $200 billion available for states and localities, and pledging federal support for laid-off workers, which relieved state unemployment funds. 

On April 9, the Federal Reserve established the Municipal Liquidity Facility (MLF), which would offer the equivalent of monetary-policy assistance for municipalities, for the first time ever. 

Policymakers understood the need to move quickly and decisively, in order to keep the market problems from getting worse, the researchers write. 

“During budget crises, the inability to issue and refinance debt at low yields could cause growing deficits to become unsustainable,” the report said. “This could result in widespread credit rating downgrades and defaults as well as cuts in spending and/or increases in taxes, as most states have to balance budgets. This would deprive taxpayers of valuable services and disposable income during times of economic distress, and eventually even impede the economic recovery.”

The researchers analyzed daily movements in state muni bond yields for correlations with indicators of economic and public health conditions, fiscal policy, the MLF, and state-level policies including emergency declarations, closures, gathering recommendations or restrictions, and stay-at-home orders. 

Then they project the counterfactual: what would have happened without the fiscal or monetary policy? The analysis covered about two months: March 2, 2020, through May 5.

“A key insight of this exercise is that fiscal policy contributed twice as much as monetary policy to the notable decline in shorter-term muni-Treasury spreads,” that is, how much higher an interest rate investors would demand to hold muni bonds. “At longer maturities, the contribution of fiscal policy becomes three times as large as that of monetary policy,” they write.

Earlier coverage: The Fed’s COVID-era municipal lending program worked for Illinois

Despite that and in spite of the fact that only two borrowers tapped the MLF, it’s important to note that it still played a critical role in calming markets, simply by introducing the Fed as a lender of last resort. That helped municipalities manage cash flow pressures.

Also, the researchers note, “the MLF provided a backstop, keeping liquidity in the market, and encouraged private investors to reengage in muni securities.”

Even though fiscal policy isn’t designed to address financial market conditions, “we find it had a larger and more persistent impact than the MLF on muni bond yields,” the researchers say. But they point out that all the benefits of fiscal policy come at much greater cost: $550 billion of government money went to states, while only $6.6 billion was borrowed via the MLF. That said, fiscal movements were also likely to have an impact on the broader economy as well, they point out. 

“Overall, our results indicate that the MLF, amid a few important extensions to its eligibility criteria, has been a helpful addition to the Fed policy toolkit,” they conclude, with a suggestion that it might be made even more effective by loosening restrictions in the future. 

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