When the COVID shock hit in early 2020, many central banks were still struggling to boost inflation after being below target the last decade. The abruptness and speed of the economic deterioration, the sharp increase in market volatility, and the blinding uncertainty about the impact of the pandemic in an environment of already low inflation, motivated a central bank reaction that was unprecedented in terms of speed, scope, and size. This was not a standard recession, triggered by overheating or financial excesses; it was akin to an induced economic coma (Deb et al. 2020). A different recession required a different response. Short-term interest rates, which were already low in most advanced economies, were quickly cut around the world, reaching around zero in all advanced
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When the COVID shock hit in early 2020, many central banks were still struggling to boost inflation after being below target the last decade. The abruptness and speed of the economic deterioration, the sharp increase in market volatility, and the blinding uncertainty about the impact of the pandemic in an environment of already low inflation, motivated a central bank reaction that was unprecedented in terms of speed, scope, and size. This was not a standard recession, triggered by overheating or financial excesses; it was akin to an induced economic coma (Deb et al. 2020). A different recession required a different response.
Short-term interest rates, which were already low in most advanced economies, were quickly cut around the world, reaching around zero in all advanced economies and even in some emerging market economies (Figure 1). Although there was widespread agreement that fiscal policy and health policy would play the lead role in fighting the pandemic and generating a recovery, monetary policy still had a critical role to play as markets froze, capital flows to emerging markets collapsed, and economic activity slowed sharply. As a consequence, central banks quickly turned to the measures adopted during the Global Financial Crisis (GFC). They revived tools and facilities that had previously been developed, and then expanded on them and introduced an entirely new set of programmes to support additional segments of the economy (Cantu et al. 2021).
Figure 1 Central bank policy rates: Pre-covid to pandemic
Note: Emerging market central banks are categorised based on the Bank for International Settlements’ definitions of “Developed” and “Emerging/Developing.”
A new CEPR eBook (English et al. 2021) discusses the range of actions taken by sixteen central banks from both advanced and emerging economies in response to the COVID shock, the lessons learned, and the unresolved questions raised by this expansion in central bank interventions. While the specific actions by each central bank were logically determined by the idiosyncrasies of their economies and institutions, there are several common threads: the size, speed and breadth of the responses; the reliance on a more multidimensional set of tools (such as asset purchases, liquidity and credit support, and regulatory easing); and the ability of emerging markets to use tools countercyclically and behave more like advanced economies. These extraordinary actions raise a number of important questions for the future of monetary policy and central banks more broadly.
Download Monetary Policy and Central Banking in the Covid Era here
A multidimensional response
The eBook includes chapters summarising the actions taken by central banks in eight advanced economies and eight emerging market economies, including the economic context in which these actions took place and justifications for the responses (see the table of contents below). The Covid shock presented a problem that had never been faced before – a global sudden stop of economic activity caused by a pandemic. It was an environment of Knightian uncertainty that made forecasting growth and inflation extremely challenging. Indeed, in the spring of 2020 a few central banks decided not to provide their usual forecasts. In addition, financial markets reacted sharply and violently to the shock, with a ‘dash for cash’ that generated dislocations in financial markets, including the most liquid market of all, the US Treasury market. These market distortions raised concerns that the channels through which monetary policy usually worked might not function as expected.
In response, central banks acted quickly and aggressively, deploying a range of tools in a multidimensional strategy to address overlapping challenges. These tools can be roughly divided into four categories (see Table 1):
- First, rate cuts and forward guidance to ease strains in markets as well as support aggregate demand and help economies to rebound.
- Second, asset purchases to address widespread dysfunction in key financial markets and, later, to provide additional support for aggregate demand.
- Third, liquidity provision and credit support (lending to financial firms, purchases of corporate securities, direct lending to nonfinancial firms, and Funding-for-Lending type programs to support bank lending), often done in conjunction with governments to support the provision of credit to businesses to ensure that viable firms could survive the crisis and would be able to ramp up production and support employment once the crisis ebbed.
- Finally, and closely related, regulatory easing (such as reductions in the countercyclical capital buffer (CCyB) and other reductions in requirements for liquidity and capital buffers) to ensure banks would not amplify the contraction in credit and liquidity to meet regulatory standards.
Sources: Individual chapters (see note 3).
Notes:  Central governments only. State or regional governments are inlcuded in the “Other assets” column.  Includes funding for lending programs as well as other steps to reduce lending costs, including targeted reductions in reserve requirements.  We thank Rochelle Edge and Nellie Liang for providing central-bank-level information for these columns. See their chapter for additional discussion of these policies.  The CCyB was zero prior to the pandemic.  The policy rates in the euro area, Switzerland and Japan were already negative. They were not reduced further.  The BoJ already had strong forward guidance in place prior to the pandemic, and it did not change that guidance.  The SNB strengthened forward guidance on its willingess to use FX intervention.  In addition to securities purchases, temporary funding was provided to the government through Ways and Means arrangements. In the case of India, Ways and Means advances were also provided to state governments.  The BCB got temporary authority to purchase government and private bonds, but didn’t do so. The authority helped stabilize those markets. Similarly, the CBCh got athority to buy government securities, but didn’t do so. Again the authority helped stabilize the market.  Brazil’s swap line with the Federal Reserve was “active, but not used” -- see chapter for discussion.  Chile provided dollar liquidity support but did not intervene in FX markets to affect the exchange rate.  The PBOC took steps to “advance RMB exchange rate formation mechanism reform”; see chapter for discussion.  The South African Reserve Bank regularly reports model results that provide a policy path for the next year.
This multifaceted response by central banks to COVID ended the arbitrary distinction between ‘conventional’ and ‘unconventional’ policies. Using forward guidance, buying assets, more generous lending programmes, and adjusting macroprudential measures all became common tools of monetary policy. Even if many of these programmes and measures are unwound as economies recover, central banks will be operating over coming years with much larger balance sheets and a wider range of exposures, and it will be much easier to reinstate these measures in response to a future crisis.
As central banks adopted this range of policies and added to their toolkit, the motivation for action varied across central banks and time. Most central banks initially adopted a ‘whatever it takes’ approach focused on market stabilisation. This approach helped justify large and rapid purchases of government bonds and intervention in private markets in ways that had previously never occurred. Exactly which markets were supported, and the mechanisms used, varied across countries. As markets recovered and economies began to rebound, however, most central banks adjusted their communication to refocus their actions on meeting their traditional inflation and growth mandates. Also noteworthy, despite central banks’ willingness to experiment with a variety of new tools, there was one ‘old’ tool that was not used – cutting policy interest rates to negative (or to further negative levels for central banks that were already at negative levels).
The chapters in the part of the book that focuses on emerging market central banks show another important common thread – a striking change from the responses to past recessions and crises. Many emerging markets were not only able to lower policy rates sharply, but also use asset purchases and other ‘new tools’ without generating a negative market reaction. For the subset of emerging market economies that relied on FX intervention, more accumulated reserves (instead of spending them) by the end of the year, and very few used capital controls. Indeed, in many ways the response of emerging market central banks to the COVID shock was similar to that of advanced economies. This is noteworthy, as emerging markets have traditionally been more constrained in their ability to respond to ‘risk-off’ shocks. This ability to use monetary policy and other tools countercyclically in response to a global shock reflected several factors:
- First, the existence of FX swap agreements helped central banks limit the tensions in FX markets.
- Second, the very fast and aggressive reaction by the main advanced economy central banks stabilised financial markets and contained risk aversion.
- Third, the general understanding that this shock was not caused by domestic imbalances or policy mistakes meant that financial market participants were less likely to withdraw capital in response to policy actions taken to support economies and even governments. Instead, there was widespread appreciation that aggressive policy support was the optimal response to a health pandemic to reduce scarring and support a more rapid recovery.
- Finally, many emerging markets had better macroeconomic and policy fundamentals than in past crises, such as smaller current account deficits (which reduce reliance on capital flows), larger reserve stockpiles, more flexible exchange rates, more credible inflation targeting regimes, and a greater ability to absorb sharp currency depreciations.
Of course, the ability of individual emerging markets to deploy these tools hinged on the soundness of their fundamentals and individual situations. Some countries chose not to pursue asset purchases (even after obtaining the legal authority to do so), and others were only able to use these tools to a very limited extent. The distinction between advanced economies and emerging markets no longer appeared to be about the tools available, but instead about having sound fundamentals and the institutional framework to use them.
Lessons learned and open questions
As countries begin to recover from the pandemic, the landscape for monetary policy and central banks has fundamentally changed in a number of ways relative to before the GFC. The chapters in the final section of the book discuss some of the lessons learned and the issues that central banks will need to address in coming years. These key issues are discussed in more detail and summarised at the end of the our introductory chapter.
- First, interest rates in jurisdictions covering over 20% of the world’s GDP (and over 10% of the world’s population) have been zero for well over a decade – and in some parts of the world substantially longer. Can central banks stabilise inflation in a low r* world, or will they need to further expand their toolkit and/or adjust their policy frameworks? What are the benefits and risks of flexible inflation-targeting regimes and of deeper coordination with fiscal policy?
- Second, the policies implemented in response to the GFC and Covid shock have left central banks with very large balance sheets. The limited ability of central banks to unwind previous purchases suggests that central bank balance sheets will be large for years to come. Does the size of central bank balance sheets matter? Even if the size does not matter from an operational standpoint, should central banks prioritise reducing the size of their balance sheets (possibly before raising policy rates) in order to create policy space for the future, limit political risks, or address market developments generated by larger balance sheets? Is there a way to differentiate between balance sheet actions done for market stability reasons and those to support real activity, making it easier to unwind the former?
- Third, central banks have taken extraordinary actions to support financial markets and economies twice in twelve years. These actions may have bolstered the impression that there is a central bank ‘put’ – i.e. that central banks will always step in to support markets and limit investors’ losses. That expectation could lead to more risk taking by investors and undermine financial stability in the future. How can central banks balance the need to stabilise markets with the potential for moral hazard?
- Fourth, the pandemic crisis was the first test of the post-GFC regulatory structure. The global banking sector held up well and was able to support the recovery rather than amplifying the shock. But this required extensive liquidity support. Were the post-GFC macroprudential reforms successful? Or will they need adjustments to recalibrate recent capital and liquidity requirements and the scope of intervention? And how should central banks and regulators address the possibility that higher standards for the core of the financial system shift risk-taking to the periphery, where firms may be less able to manage risks and policymakers may be less well informed?
- Finally, as central banks have taken on roles that extend their focus beyond simply meeting inflation (and sometimes employment) goals, they are paying more attention to inequality, climate change, and other issues that go beyond their formal mandates. Are central banks doing too much? Should they take on more? Will these additional mandates interfere with their ability to achieve their primary objectives?
While the pandemic is still far from over, a preliminary assessment suggests that central banks have effectively responded to the initial phases of the Covid shock – through a combination of forceful monetary policy that built on the programmes first tried in response to the GFC, combined with an entirely new set of initiatives to directly support financial markets and provide credit to the economy. This response has entailed an unparalleled expansion of reach – well beyond the narrow inflation-targeting focus of most central banks. These programmes were crucial to stabilise economies and financial markets when economies were locked down and while vaccines were developed and rolled out, but this expansion of reach and responsibilities also raises numerous questions about monetary policy and the role of central banks in the future. Moreover, the recovery from the pandemic will also likely have additional extraordinary features, and central banks will have to continue to be flexible and nimble to respond successfully.
Authors’ note: The views or opinions expressed in this column and the eBook are solely those of the authors and do not reflect the views, policies, or positions of Citadel.
Cantu, C, P Cavallino, F de Fiore and J Yetman (2021), “A global database on central banks' monetary responses to Covid-19”, BIS Working papers 934
English, B, K Forbes and A Ubide (2021), Monetary Policy and Central Banking in the Covid Era, CEPR Press.
Deb, P, D Furceri, J Ostry, and N Tawk (2020), “The Economic Effects of COVID-19 Containment Measures”, VoxEU.org, 17 June.
Part I: Introduction, overview, and economic background
Monetary policy and central banking in the Covid era: Key insights and challenges for the future
Bill English, Kristin Forbes and Angel Ubide
A year like no other
Gian Maria Milesi Ferretti
Part II: The central bank responses in advanced economies
Monetary policy in Australia during Covid
The Bank of Canada’s response in 2020 to the Covid-19 pandemic
Toni Gravelle and Carolyn A. Wilkins
The monetary policy response in the euro area
Philip R. Lane
The Bank of Japan’s monetary policy in the time of Covid-19
The response in Sweden
The Swiss National Bank’s monetary policy response to the Covid-19 pandemic
Thomas J. Jordan
The Bank of England’s response to Covid-19
The COVID-19 crisis and the Federal Reserve’s policy response
Richard H. Clarida, Burcu Duygan-Bump and Chiara Scotti
Part III: The central bank responses in emerging economies
Brazil: Covid-19 and the road to recovery
Fernanda Nechio and Bruno Serra Fernandes
The Central Bank of Chile’s policy response to the Covid-19 crisis
Pablo García Silva
The People’s Bank of China adhered to normal monetary policy and enhanced support to the real economy to offset the impact of Covid-19
The response of the Reserve Bank of India to Covid-19: Do whatever it takes
Bank Indonesia’s response to Covid-19: Synergise to build optimism for economic recovery
Bank of Russia policy during the Covid-19 pandemic
Weathering Covid: South Africa’s central bank policy in 2020 and 2021
Monetary policy in the Covid era: The Turkish experience
Part IV: Evaluation of the responses and implications for the future
Central banks and the Covid-19 economic crisis
Assessment of monetary and financial policy responses in advanced economies to the Covid-19 crisis
Laurence Boone and Łukasz Rawdanowicz
The year the power of central bank balance sheets was unleashed
Emerging markets during Covid-19: Unconventional policies and financial markets
Dimitris Drakopoulos, Rohit Goel, Evan Papageorgiou, Dmitri Petrov, Patrick Schneider and Can Sever
Central banking and credit provision in emerging market economies during the Covid-19 crisis
Luis Felipe Céspedes and José De Gregorio
A global shock to a global system: Covid-19 and the post-2008 regulatory framework
Macroprudential bank capital actions in response to the 2020 pandemic
Rochelle M. Edge and J. Nellie Liang
Looking forward: Monetary policy post-Covid