Richard Harrison, Kate Reinold and Rana Sajedi
The Covid shock has created substantial and unprecedented challenges for monetary policymakers. This post summarises the key literature on the immediate monetary policy response to the shock, including both tools and short to medium-term strategy issues (but leaving aside the longer-term question of fiscal-monetary interactions).
Demand vs supply shocks
An early literature looked at modelling how the sectoral Covid shock affects the balance of demand and supply. Subsequently, the empirical literature has attempted to determine which channel dominates, and found that the answer differs across sectors and at different horizons. In general, the evidence suggests that, at least in the near term, deflationary demand shocks are larger, although a minority of papers argue supply is more important (Brinca, Duarte and Castro (2020) and del Rio-Chanona et al (2020)). Using forecast revisions in US survey data, Bekaert, Engstrom and Ermolov (2020) find a decline in inflation driven by a negative demand shock. Alvarez and Lein (2020) and Balleer et al (2020) use debit-card transaction data in Switzerland, and firm-survey data in Germany, respectively, and also find evidence of a decline in inflation during the first months of the pandemic.
Alternative economic mechanisms
The unprecedented nature of the Covid shock has also increased interest in other potential mechanisms at play. Caballero and Simsek (2020) highlight a novel role of financial markets in the transmission of the Covid shock, which they call the ‘Wall Street/Main Street disconnect’. US asset prices reacted quickly to news about the pandemic, and then recovered sharply following the Fed’s monetary expansion. Unemployment increased gradually and remained high. They rationalise the Fed’s policy in a model in which aggregate demand is sluggish, responding to asset prices with a lag. Optimal policy requires a sharp initial overshoot of asset prices to offset future contractionary forces on aggregate demand, given the stickiness of spending decisions.
Covid has also led to heightened uncertainty. Pellegrino, Castelnuovo and Caggiano (2020) show that financial uncertainty shocks have real-economy effects. They find that US monetary policy responded more aggressively to output after the Global Financial Crisis (GFC), and, by doing so, offset around half of the losses of the uncertainty shock. The Covid uncertainty shock could generate output losses twice as large as the GFC, but again a suitably aggressive monetary policy response could reduce these losses by around half. A large literature (see Mendes, Murchison and Wilkins (2017)), has looked at the conduct of monetary policy in the presence of broad-based uncertainty. De Grauwe and Ji (2020) show that during crises it is better for monetary policy to respond to current data, rather than forecasts, due to the uncertainty around the economic outlook. Bordo, Levin and Levy (2020) propose the explicit use of different clinical/epidemiological scenarios (eg whether or when an effective vaccine is developed) in central bank strategy and communications, to illustrate profound non-economic uncertainty and its potential implications for the path of policy.
The heterogeneous sectoral effects of Covid has prompted research on what optimal monetary policy can do for sectoral reallocation of resources. Woodford (2020) shows that, with a ‘Covid shock’ driving activity in some sectors below welfare-maximising levels, monetary policy cannot offset cross-sectoral distortions and so cannot stabilise the effects of these shocks. This is similar to the result found in a paper on production networks, in which no monetary policy can implement the first-best allocation (La’O and Tahbaz-Salehi (2020)). Woodford argues that targeted fiscal transfers are better suited to addressing demand deficiencies, and may be able to achieve the first best allocation of resources without any need for a monetary policy response.
Tool choice and efficacy
Covid has hit at a time of historically low international policy rates and large central bank balance sheets, when central banks were already re-thinking their toolkits. Alongside the short-term demand consequences, Jordà, Singh and Taylor (2020) find that the equilibrium interest rate has fallen persistently after past pandemics, which would further reduce the policy space available for rate setters. This raises the prospect that policymakers will need to routinely reach for unconventional tools developed since the GFC, and potentially to countenance some new ones.
Research is underway on the effects of central bank interventions since March 2020. Hartley and Rebucci (2020) study QE announcements across 21 central banks and find that the declines in 10-year government bond yields in developed market economies were slightly smaller than those seen in the aftermath of the GFC. Altavilla et al (2020) find that the co-ordinated actions of monetary and prudential policymakers in the Eurozone was particularly effective at supporting bank lending. Less encouragingly, Coibion, Gorodnichenko and Weber (2020) find that the beliefs and spending plans of US households did not respond to forward guidance post-Covid.
At the same time, theorists are hard at work looking at the mechanisms at play for unconventional tools. Sims and Wu (2020) distinguish between lending to the financial sector (‘Wall Street QE’) and to non-financial firms (‘Main Street QE’). If a shock impairs financial firms’ balance sheets (eg, the GFC), the two types of QE are perfect substitutes. But for a shock in which non-financial firms face cash-flow shortages (eg, the Covid shock), ‘Main Street QE’ is substantially more effective, given that it supports firms reliant on debt finance. Caballero and Simsek (2020) argue that a large non-financial shock, such as Covid, generates an endogenous fall in risk tolerance. In this case, QE can mitigate the effects of the shock by transferring risk to the central bank’s balance sheet.
Levin and Sinha (2020) analyse the efficacy of forward guidance at the lower bound in a model incorporating frictions in expectations formation, imperfect credibility of policy commitments and the central bank’s uncertainty over the structure of the economy. This framework suggests that forward guidance requires long-lived promises of inflation overshoots, and may therefore be counterproductive if the baseline model of the economy is misspecified. The authors therefore argue that going beyond current FOMC guidance, which they view as intended to clarify the FOMC’s reaction function and close to current market expectations, could bear risks.
Covid has also reinvigorated the debate on the blogosphere on the merits of negative interest rates, although the academic literature on this is still sparse. There are different positions on the effectiveness of past experience. For example Andersson and Jonung (2020) suggest that negative rates in Sweden in 2015–19 had a modest effect on inflation but contributed to increased financial vulnerabilities, while Krogstrup, Kuchler and Spange (2020) argue that the period since the Danish policy rate went negative in 2012 has been more benign. Others have made the case that negative rates will be an invaluable tool for inflation targeting, given market expectations of the need for further easing (eg Lilley and Rogoff (2020) and de Groot and Haas (2020)). This is sure to prompt more future research.
Conclusions
As highlighted in this post, the Covid shock has lit a spark under several new monetary-strategy research themes (eg sectoral differences, new QE mechanisms), but also stoked the flames on a number that have been simmering for a while (uncertainty, unconventional policy tools close to the ELB, equilibrium interest rates). This post has not addressed the recent debate on monetary-fiscal interactions and helicopter money.
Richard Harrison works in the Bank’s Monetary Analysis Division, Kate Reinold works in the Bank’s Monetary Policy Outlook Division and Rana Sajedi works in the Bank’s Research Hub.
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