The Trump Administration is to shut down the emergency lending powers of the US Federal Reserve, taking extraordinary action to block reserve funds for the incoming Biden Treasury and prevent a Democrat bail-out of state and local governments.
The pre-emptive strike marks a breakdown in the normal co-operation between the US Treasury and the Fed, and comes just as the winter wave of Covid-19 reaches a crescendo. The services sector is already spiralling back into contraction, with a cliff-edge approaching for jobless support.
"We are in a perilous moment for the economy," said Jason Furman, the former head of the White House Council of Economic Advisors.
Vaccine euphoria has lifted Wall Street to record highs but evisceration of the Fed's backstop powers before the pandemic is over threatens to destabilise parts of the credit system.
The US Treasury Secretary, Steve Mnuchin, has told the Fed that he will not roll over five of its nine Great Depression powers under the Article 13 (3) of the Federal Reserve Act. There will be a suspension of its lending facilities for companies, local governments, and 'Main Street' loans at the end of the year.
"The most obvious interpretation is that the Trump administration is seeking to debilitate the economic recovery as much as possible on the way out of the door," said David Wilcox, the Fed's former chief economist, now at the Peterson Institute.
"Circumstances are very tenuous at the moment. If the situation unravels and really goes South this could prove to be a very damaging step. Secretary Mnuchin will go down in history as the man who took away a safety net when it was really needed," he said.
The Treasury also instructed Fed Chairman Jay Powell to return the unused portion of a $454bn account approved by Congress during the market meltdown in March.
This seed money gave the Fed $4.5 trillion extra lending power under a policy of 10:1 leverage and had an electrifying effect on market confidence – avoiding the errors made in 2008.
Roughly $250bn remains and could be amplified into a real lending bazooka under Joe Biden if Congress blocks his reflation plan. It has therefore become a high stakes bone of contention.
Krishna Guha from Evercore ISI said the Fed's "market stabilisation policy" had been politicised. "The move will shut down the corporate credit programmes that were hugely successful at restoring market functioning in the spring and have operated as backstops since, fostering strong credit market conditions and indirectly supporting the equity market," he said.
The Federal Reserve issued a plaintive statement warning that the "full suite of emergency facilities" remain necessary as a backstop for "our still-strained and vulnerable economy".
Congressman Bharat Ramamurti, a member of the House oversight committee on stimulus, called Mr Mnuchin's move "an unjustified and ideological decision by the Treasury Department. It is incumbent on the Fed to reject this request". That would be courting fate.
The Fed retains its monetary policy powers and can purchase further US Treasury bonds but that is a blunt tool at this juncture unless it is married to aggressive fiscal expansion, which the Republican Senate has vowed to block. "QE is a very imperfect substitute for a credit market backstop," said Mr Guha.
The Fed is concerned that more QE will chiefly inflate asset prices without doing much to help the real economy, exacerbating social inequality. The central bank's moral doctrine under Mr Powell – a 'one-nation' patrician conservative of the old school – is akin to a monetary Hippocratic Oath, that it should not undertake any measures that further damage the social fabric or that leave poor people behind.
Congress stripped the Fed of its discretionary powers under Article 13 after the Lehman crisis. The Fed now needs permission from the Treasury to go beyond its normal mandate. This was granted immediately during the panic in late March.
The crucial action then was to mop up the corporate bonds of junk-grade 'fallen angels', preventing a cascade of forced sales and a financial chain reaction. The lending facilities acted chiefly through psychological and confidence effects. The markets knew that the Fed stood behind the system in extremis.
The incoming Biden Administration will be able to renew the Fed's Article 13 powers in late January but that does not imply a return to the status quo ante. The key lending facilities in question are anchored in seed funding from Congress.
Mr Munchin has demanded that this money now be returned to Congress. Since the Republicans have no intention of funding Mr Biden's Keynesian expansion and are likely to retain control of the Senate, there is little chance that the Fed's credit tools will be revived.
Senator Patrick Toomey, the expected chair of the Senate banking committee, said emergency credit facilities were no longer needed now that there is ample liquidity. He says it was never the intention of the Senate that Joe Biden should be able to use residual funds to bail out insolvent state and local governments.
Gregory Daco from Oxford Economics said a Biden Treasury can still raid $70bn of uncommitted funds in the Treasury's Exchange Stabilisation Fund (normally used for currency intervention) but this is a popgun by comparison. "We estimate its lending firepower would be 10 times smaller," he said.
The market fall-out from this dispute is far from clear. The Fed may be forced to step up QE in order to compensate for the loss of its credit instruments. The economy may muddle through if vaccines come soon enough and optimism holds up. But risks are mounting.
"I think markets are incredibly complacent about this. The riskier high yield end of credit is going to be very vulnerable. We thought we had a comfort blanket that covered everything and now we don't know what is going to be eligible," said Marc Ostwald, a credit veteran at ADM. "A lot of companies are borrowing to cover current costs and survive. They can't carry on like this. They are either going to have to restructure dramatically with a lot of lay-offs or they're going to be insolvent. That moment is hitting now," he said.
Edward Harrison from CreditWritedowns said a "double-dip" was now the base case for the US economy. "We have a fiscal cliff staring us in the face," he said.
The main pandemic support for those unable to work expired at the end of July and many are running down their savings. A fresh relief bill has been scuppered by gridlock on Capitol Hill.
Roughly 12 million will lose the last of their unemployment support when the guillotine comes down after Christmas, unless Congress acts very soon.
The Fed's Mr Powell says widespread vaccination is still months away. In the meantime, small firms are under enormous stress and prolonged joblessness is leading to labour hysteresis. "From the very start, we've been concerned about longer-run damage to the productive capacity of the economy," he said.
Mr Powell says fiscal stimulus is "absolutely essential" but the chances of it actually happening are receding. Now his own credit wings have been clipped. All that remains is raw monetary policy.
A potent economic recovery beckons once life returns to normal in mid-2021. Getting from here to there is going to be a stormy ride.