This informal CPD article on Central Banks and the Covid-19 Crisis was provided by Robert Jacek Wlodarski, research intern at the Institute of International Monetary Research.
Having developed from a local health emergency to a world pandemic, Covid-19 very quickly inflicted a heavy blow to the global economy. With economies spiralling downwards and governments busy with emergency measures to support the economy, central banks have intervened very aggressively too. They have cut the interest rates to nearly zero, applied forward guidance, provided extraordinary funding facilities to banks and non-financial companies, and embarked on unprecedented quantitative easing programmes. Compared to the responses to the Global Financial Crisis (GFC), this time things are really different; central banks have been much more willing and ready to provide monetary stimulus to the economy. The current crisis, however, is of a different nature; it has not been caused by a demand-side shock, let alone a financial crisis as in 2008, but mainly by a supply-side shock (though undoubtedly with spill-over effects on demand).
As the core central banks had already reduced their interest rates to near- or sub-zero territories, such conventional policy measures are ineffective at boosting the aggregate output further and meeting inflation targets during the height of the recession triggered by the Lockdown. One option is to set negative interest rates. This is not a desirable option; negative interest rates produce distributional effects that could hurt risk-averse individuals and institutional investors, such as pension funds. Unsurprisingly, central banks have been very cautious when it comes to negative interest rates. They are, however, eager to reduce uncertainty through forward guidance, another ‘innovation’ in the way central banks communicate their policies since the aftermath of the GFC. A commitment that policy rates are to remain low for a period of time reduces economic uncertainty and shows central bankers’ intentions.
Further, central banks can do much more than that and this crisis has shown once again that, under the current fiat monetary systems, central banks cannot run out of ‘ammunition’. With the interest rates at historically low levels already before the recession, central banks decided to send a very powerful message to financial markets by resuming and even expanding their asset purchase programme so-called Quantitative Easing (QE). The US Federal Reserve alone committed itself to unlimited bond purchases, while similar if more modest measures by other central banks have already resulted in an extraordinary surge in the amount of money supply in the world’s leading economies. What stands out, however, is the record-high level of US money growth in modern (peacetime) era (higher than 25% on annual basis in June 2020). True, under scenarios of high uncertainty, people tend to hold more cash. But once the pandemic is more under control, they will gradually resume their spending patterns, but with a much greater amount of money in the economy.
Unlike the GFC, the reaction to Covid-19 by central banks will likely lead to inflation in the medium term unless efforts are made quickly to run off the asset purchases soon after the economy recovers. As yet, Andrew Bailey, the governor of the Bank of England, is the only Central Bank governor to have mentioned this possibility.
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