COVID-19 and monetary policy: Is it time to be unconventional?

By Stephanie Kannimmel, BSc Philosophy, Politics and Economics student at King's College London

In the presence of liquidity traps, such as during the financial crisis and in Japan after the 1992 bubble burst, governments turned to unconventional monetary policy instruments to avoid deflation when conventional instruments failed to work. The use of unconventional monetary policy instruments increased particularly during the global financial crisis. Some policies, such as quantitative easing, have become considered conventional instruments today, especially for economies constrained by the zero-lower bound.

With a global slowdown occurring again due to COVID-19, expansionary monetary policy measures have been undertaken by central banks worldwide to attempt to stimulate the economy. However, the presence of already low interest rates before COVID-19 has made it so central banks have had less leverage with regards to conventional monetary policy tools than in response to other recessions. Therefore, the question arises of whether unconventional policies are necessary to tackle the economic impacts of COVID-19.

In order to address this question, it is necessary to look at the backdrop of structural changes in the global economy before COVID-19. Just before the pandemic hit, global debt hit a record level of 322% of global GDP, much of which was in the non-financial corporate sector. Government debt has also increased significantly since 2008, which is to be expected considering the financial crisis and the provision of fiscal stimulus financed from budget deficits. Household debt has also increased since then, as deleveraging did not occur for households as it did in the financial sector. Additionally, aging populations are prevalent in several world economies. This has contributed in part to a downward trend in the velocity of money.

Considering the failure of conventional monetary policy in certain cases, the state of the global economy before COVID-19, and that more expansionary fiscal policy than usual was needed to mitigate the effects of COVID-19, it seems to follow that unconventional monetary policy instruments should be considered by central banks worldwide. The Federal Reserve and the ECB, along with many other central banks, have become more aggressive and innovative in defending economies from recession and deflation in COVID-19. As of September 2020, recent months showed the return of quantitative easing and more esoteric policies among central banks worldwide:

According to Bloomberg, it is likely that “monetary policy will stay ultra-loose for years to come – even if that means central banks artificially propping up markets or sparking a run-up in prices”. This stems from how COVID-19 has been more destructive than the financial crisis of 2008, especially given the state of the economy before the global spread of the pandemic compared to the state of the economy before the financial crisis. As such, Bloomberg projects that the move back to tighter monetary policy will take as long (if not longer) than in the post-financial-crisis period.

Therefore, unconventional policy instruments, especially in emerging market economies, can cushion the impact of COVID-19 and support recovery while also increasing central banks’ monetary policy space to help them meet their output and inflation goals. This can be seen in lower interest rates in the midst of the pandemic compared to the beginning, and in quantitative easing measures taken by emerging economies:

Although conventional monetary policy measures may not have worked for several economies during COVID-19, the necessity of unconventional policy instruments depends on the actions on central banks before the pandemic. For example, if a central bank increased their purchases of assets and bonds before the pandemic or at a time where interest rates were not near zero (a policy measure different from quantitative easing), they may not need to resort to unconventional policy measures.

Furthermore, unconventional policy measures such as quantitative easing may not work to revive real economic activity in certain cases such as in Japan after the 1990s, simply propping up asset prices instead. Quantitative easing can thus lead to a bifurcation where recovery occurs in the stock market, but stagnation persists in the real economy, leading to a “K-shaped” recovery pattern. Furthermore, the credibility of the central bank must be especially established in order to ensure the success of unconventional policy measures for households, firms, and investors to set rational expectations. This depends on the central bank’s policy history (e.g. inflation targeting) and the state of the economy. For quantitative easing in particular, the availability of high-quality domestic assets, the presence of a well-developed financial sector, and the structure and liquidity of capital markets are also important considerations.

A potential alternative to negative or near-zero interest rates and quantitative easing is Modern Monetary Theory (MMT). MMT involves a consolidated central bank with the budget constraint of the government, and almost permanent government expenditure financed by the permanent printing of money, where the only limit to government spending and money creation is inflation. MMT is very attractive politically due to its redistributive effects and the recent phenomenon of many developed countries falling into liquidity traps, and is thus likely to become part of mainstream policy in the coming years.

According to economist Peter Bofinger, MMT could be a good way to mitigate the effects of COVID-19, especially considering that inflation risks are low due to the deflationary impact of the pandemic. However, MMT may not be suitable for smaller economies that have financial constraints for supporting individuals and firms during and after shutdowns. Furthermore, stimulating consumption with MMT may be counterproductive to government interest during lockdowns. Therefore, MMT may be more suitable for larger economies than emerging market economies during COVID-19.

Ultimately, the success of unconventional monetary policy in mitigating the effects of COVID-19 depends on the credibility of the banking system and existing monetary policy frameworks, good governance, and the structure and state of the economy. Without considering these factors, fiscal dominance, depreciation pressures, and increased risk premiums are among several risks that central banks may have to face. While unconventional policy instruments innovatively solve the problems of traditional monetary policy in ways tailored to a contemporary economic climate, it is still difficult to tell what the long run impacts of such policies could be. Therefore, a careful assessment of the above factors by central banks is crucial to determine both the necessity of and the potential success of using unconventional policy instruments to stimulate the economy.

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