Speaking at the UBS High-level Discussion on the Economic and Monetary Policy Outlook, held in Zurich on 27 May 2020, Agustín Carstens, General Manager, Bank for International Settlements, discussed the economic impact of Covid-19, and policy response of advanced economies’ central banks.
Carstens remarked that the global lockdown following the Covid-19 pandemic has resulted for the first time ever that the global economy has been put in an induced coma. This has been a policy choice resulting from the need to avoid a health disaster. The policy challenges posed by this pandemic have been unique and unfamiliar. As Carsten explains,
“On the demand side, lockdowns and social distancing have made consumer spending highly insensitive to policy stimulus. On the supply side, containment measures ordered by governments have directly hindered production, with the repercussions spreading through local and global supply chains. These disruptions could leave permanent scars on the economy if they result in large-scale layoffs and bankruptcies. The pandemic also profoundly shook financial markets. As events unfolded, heavy sell-offs across a wide range of assets and a sharp tightening of financial conditions threatened to derail the economy even further.”
In policy initiatives which have been unprecedented, at least since the Second World War, governments, central banks and supervisory authorities have “responded boldly, decisively and imaginatively to limit the consequences of simultaneous sudden stops in spending, economic activity, funding and financial market functioning”.
Fiscal stimulus, including the provision of credit guarantees, has also been, as a percentage of GDP, the highest since the Second World War. Financing the deficits, without affecting the financial markets, will be a challenge.
Central bank measures included reducing policy rates and “large-scale balance sheet measures.” This underlined the critical role of central banks as no other body, government or private, can raise resources on the same scale and speed as central banks can. These measures included large-scale purchases of government debt to reduce its borrowing costs and provide liquidity to the bond markets. They also included credit support to firms, including small and medium enterprises, and households. As Carsten explains, “The main objective is to prevent liquidity strains that could lead to bankruptcies of solvent firms and leave long-lasting scars on growth potential. These extraordinary actions were designed precisely to flatten the mortality curve of businesses.”
These measures, especially the support to the bond markets, according to Carstens, “reflects the rarely employed role of the central bank as a market stabiliser and financing intermediary between the fiscal authorities and financial markets. This should be temporary, limited by its intent and scale, and in line with the financial stability mandate of central banks. These actions are meant to smooth the impact of a sudden ramp-up of fiscal spending induced by an extraordinary but, we hope, transient event.”
Carstens divides the life cycle of this induced crisis into three phases: liquidity, solvency and recovery. According to him, many countries are at the end of the first stage, where monetary policy would be more effective. In later phases, fiscal and structural policies will have to take the responsibility of preventing further damage.
Carstens goes on to discuss how central bank independence can be ensured at a time of central bank balance sheets growth, and increasing fiscal-monetary policy nexus. He lists three safeguards.
First, ensure fiscal sustainability, to avoid perceptions that debt could be inflated away. This would include “crafting strong intertemporal fiscal strategies, reining in future spending and developing sound revenue policies. But the most direct route to fiscal sustainability lies in boosting growth potential. This means implementing structural reforms to lift potential growth rates, mitigating failures of healthy firms, orienting fiscal policies towards investment, preserving global supply chains and safeguarding free trade.”
Second, central banks should remain focused on macroeconomic stability, especially price and financial stability. Carstens urges clear articulation of the policy objectives and exit strategies, preserving institutional governance, obtaining government indemnities for potential central bank losses, and avoidance of “overt deficit financing.”
Finally, Carstens warns against considering monetary policy as a long term remedy. Central bank credibility requires that the boundaries with fiscal policy are honoured and restored at the earliest. Crossing these traditional boundaries, according to him, are “only feasible for central banks in advanced economies with high credibility stemming from a long track record of stability-oriented policies. This is strong medicine and should only be taken with extreme care.”
The last warning is pertinent for emerging market economies, where I would say the first stages are more relevant for fiscal policy, and monetary policy would become effective only after supply chains are restored and market sentiment restored.
© G Sreekumar 2021
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