Central bank responses to COVID-19

Business Economics https://doi.org/10.1057/s11369-020-00189-x ORIGINAL ARTICLE Central bank responses to COVID‑19 Patricia C. Mosser1 © National Association for Business Economics 2020 Abstract Central bank responses to COVID-19 have been extraordinary in speed, in size and in scope. Much easier monetary policy, massive liquidity provision, and targeted credit support to the real economy all played a role in stabilizing financial conditions and credit. On net, there is preliminary evidence that central bank actions have been a positive—for access to credit and for the real economy—during very trying times. But the first six months have made clear that central bank policy can only indirectly address the core economic policy challenges of the crisis, whose trajectory remains highly uncertain. The risks to the economy and financial system remain very large, and key policy questions—on the degree of fiscal policy support to the real economy, about the limits of central bank risk taking and monetization of debt, and about the wisdom of heavy reliance on central bank policies given their impact on leverage and debt levels—remain just that. Keywords Monetary policy · Lender of last resort · Credit programs · COVID-19 · Central banks · Federal Reserve Central bank responses to COVID-19 have been extraordinary in speed, in size and in scope. The Federal Reserve announced as many emergency programs in eight days (March 14 to 23, 2020) as it did during all of 2008. Moreover, the Fed implemented more programs in 4 months than in the entire global financial crisis. On net, there is evidence that central bank actions have been a positive – for access to credit and for the real economy—during very trying times. But this early conclusion has two caveats: first, in a pandemic a central bank’s role is limited. At best it can cushion the blow via lending and easier financial conditions, and so provide a bridge to future economic recovery. But encouraging more leverage is a double-edge sword, since it can increase future fragility. Second, it is frankly too soon to make a serious judgment on the ultimate effectiveness of any particular set of economic policies—central bank or otherwise. Thanks to my colleagues in the Columbia University Finance Free Lunch and Macro Lunch Group seminars for comments on an earlier presentation of this material and to Charles Steindel for comments. Particular thanks to Johann Kerhousse and Doris Li for excellent research assistance. * Patricia C. Mosser 1 School of International and Public Affairs, Columbia University, New York, USA The size and speed of the response by the Fed and other central banks mirror the size and speed of the COVID-19 crisis. Typically, economic crises of this scale are preceded by financial crises. The 2007–2009 global financial crisis is a classic example; it started with a financial panic, which accelerated in spite of large central bank and fiscal interventions. The financial deterioration (panic) happened rapidly, but only over time did it drag the real economy down with it. This time exactly the opposite happened. The public health restrictions required to manage the pandemic caused enormous, instantaneous (and largely) negative shocks to both aggregate supply and demand. The real economy figuratively stepped off a cliff in March 2020 (see Fig. 1), prompting similarly large and swift policy actions by monetary and fiscal authorities. The huge sectoral differences in the impact of the crisis—shutdowns in many retail services, travel, entertainment, and hospitality, as well as non-Covid, non-emergency health care—led to a sharp drop in overall economic activity, and the prospect of massive unemployment and business failures. The unusual combination of supply and demand shocks will likely have long-term implications for the structure of the economy and growth, and they will remain a challenge for economic policy, including central banks. See Guerrieri et al. (2020). Importantly, the financial system was quite strong at the beginning of the COVID crisis, reflecting the relatively long global (and U.S.) economic expansion as well as much more Vol.:(0123456789) P. C. Mosser Fig. 1  Weekly Economic Index Source: Federal Reserve Bank of New York. See Lewis et al. (2020) robust capital and liquidity buffers in the financial system, particularly at the largest global banks. See Borio (2020). Indeed, one of the aims of central bank (and fiscal) policies since March 2020 has been to provide enough support to the real economy to prevent a large negative feedback loop from real economy bankruptcies and defaults to the financial sector. If the collapse of the real economy causes a subsequent financial crisis, then the United States and world face an even more dire outlook: the collapse of credit formation and liquidity provision by banks and other financial companies, which in turn would cause an even further step down in the economy, employment and well-being. 1 Central bank policy In response to the economic collapse, central banks, including the Fed, launched a massive set of programs to address both the real and financial distress caused by the pandemic. See Fleming et al. (2020). Like the fiscal policy responses, many of the new (or renewed) central bank programs were intended as “cushion the blow” policies to sustain credit formation, support the real economic activity by easing financial conditions, provide liquidity and reduce financial distress.1 Central bank policy actions and programs can be roughly broken into three categories: monetary policy, liquidity provision/lender-of-last-resort to the financial system, and 1 For a more comprehensive list of programs across countries, as well as associated changes to regulatory policy, see IMF (2020). and https://docs.google.com/spreadsheets/d/1s6EgMa4KGDfFzcsZJKq wiH7yqkhnCQtW7gI7eHpZuqg/edit#gid=0. targeted credit programs directed to support nonfinancial sector players: firms, households, municipalities. Importantly, these actions were accompanied by enormous regulatory relief actions, including relaxation of capital and liquidity standards, and loosening of market regulations and activity restrictions in the financial sector, again with the aim to make financing more available at lower cost.2 1.1 Monetary policy Easing monetary policy in face of a recession is standard operating procedure. Nearly every central bank on the planet has sharply cut policy interest rates (where they could do so).3 In many advanced economies, including the United States policy rates were set to their effective lower bound, and ‘unconventional’ policies such as asset purchase programs were started or expanded.4 Moreover, a number of emerging market central banks not only cut rates but began asset purchase programs (both government and private sector), some doing so for the first time.5 One notable exception 2 The list of regulatory forbearance actions and macro-prudential measures is much mo (...truncated)