The limited power of monetary policy in a pandemic

This paper was produced as part of the BIS Consultative Council for the Americas (CCA) research conference on The economics of the Covid-19 pandemic.

Summary

Focus

We analyse the role played during a pandemic by two monetary policy tools: conventional interest rate policy and forward guidance. We ask two interrelated questions. First, given the environment brought about by the Covid-19 pandemic, should we expect the transmission mechanism of monetary policy to be the same as in normal times? Second, how should monetary policy be optimally conducted in this environment?

Contribution

Our model departs from standard models used for monetary policy analysis by incorporating an epidemiological aspect. In our framework, economic decisions and virus dynamics are interlinked. In our baseline scenario, the spread of a virus leads to a ramp-up in both mandatory and voluntary social distancing measures and triggers a sizeable recession.

Findings

Our first main finding is that monetary policy is less effective in a pandemic than in normal times. In a pandemic, consumption is less sensitive to real interest rate changes as households factor the risk of becoming sick into their decisions. Our second main finding is that the optimal design of monetary policy hinges on how other tools used to limit virus spread, such as lockdowns, are deployed. If the lockdown policy is set optimally, monetary policy should focus on keeping inflation on target. However, if the lockdown policy is not optimal, the central bank faces a trade-off between its objective of stabilising inflation and the need to minimise the inefficiencies associated with virus spread. The trade-off is resolved by tightening monetary policy more the more sub-optimal the lockdown policy is.

Abstract

We embed an extension of the canonical epidemiology model in a New Keynesian model and analyze the role of monetary policy as a virus spreads and triggers a sizable recession. In our framework, consumption is less sensitive to real interest changes in a pandemic than in normal times because individuals have to balance the benefits of taking advantage of intertemporal substitution opportunities with the risk of becoming sick. Accommodative monetary policies such as forward guidance result in large increases in inflation but have only limited effects on real economic activity as long as the risk of infection is large. The optimal design of monetary policy hinges on how other tools used to limit virus spread, such as lockdowns, are deployed. If the lockdown policy is conducted optimally, monetary policy should focus on keeping inflation on target. However, if the lockdown policy is not optimal, the central bank faces a trade-off between its objective of stabilizing inflation and the necessity to minimize the inefficiencies associated with virus spread.

JEL classification: E5, E1, E11.

Keywords: COVID-19, SIR macro model, statedependent effects of monetary policy, forward guidance, monetary policy trade-offs, optimal monetary policy.