Countering Covid-19 - The nature of central banks' policy response

Opening remarks by Mr Agustín Carstens, General Manager of the BIS, at the UBS High-level Discussion on the Economic and Monetary Policy Outlook, Zurich, 27 May 2020.

It is a pleasure and an honour to participate in this panel with Thomas Jordan and Axel Weber. Axel, thank you very much for the invitation. I join Thomas in expressing my sympathy to everyone who has been affected by this pandemic and wishing all of you in the audience good health. In my opening remarks, I will briefly address the economic impact of Covid-19, to then move on to analyse the policy response of primarily the advanced economies' central banks.

No normal recession

The Covid-19 pandemic and the induced global lockdown are a truly historic event. Never before has the global economy been deliberately put into an induced coma. This is no normal recession, but one that results from explicit policy choices to avoid a large-scale public health disaster.

The unique character of this recession poses unfamiliar challenges. 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.

The policy reaction has been unprecedented. 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. In particular, it took massive and unprecedented policy actions on the part of central banks and other authorities to prevent a financial collapse that would have compounded the drop in real activity.

On the fiscal side, governments have launched massive stimulus and projected fiscal deficits on a scale not seen since World War II. A major issue will be how to finance the resulting fiscal deficits and prevent them from destabilising markets. In addition, the fiscal measures have been accompanied by far-reaching funding and credit guarantees provided by governments and/or their development banks.

The response of central banks

The sudden shock called for a speedy and massive policy response .The actions of central banks have again highlighted their central role in crisis management as they swiftly cut policy interest rates and launched large-scale balance sheet measures This brought central banks to the forefront again as they can mobilise financial resources faster than any other authority. In this round of urgent policy mobilisation, central banks' actions concentrated on large-scale purchases of government debt as well as credit support for firms and households. The latter encompassed funding-for lending schemes, purchases of corporate debt, and support provisions for small and medium-sized enterprises. This last set of measures is designed to travel the "last mile". 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.

For their part, large-scale government bond purchases aim to lower interest rates, to provide monetary stimulus and to help the liquidity and functioning of the sovereign bond markets. This comes in the context of huge borrowing needs by governments as fiscal deficits rise and debt levels surge.

The last feature 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. 

These extraordinary monetary policy actions are designed exclusively to safeguard economic and financial stability, and do not amount to fiscal deficit financing. Consistent with this, the measures undertaken by central banks have contributed to an easing of financial conditions and a calming of financial turmoil.

Setting the boundaries

We could conceptualize the life cycle of a pandemic-induced crisis as having three phases: liquidity, solvency and recovery. In many countries, we are at the end of the first stage, or at the end of the beginning, where monetary policy actions can be most effective. For the later phases, the heavy lifting should come primarily from fiscal and structural policies.

While central bank measures have been necessary and show initial success, these bring major challenges going forward in the form of a significant overlap between fiscal and monetary policy. Central bank balance sheets are bound to grow considerably this year, in tandem with a massive increase in public debt. There is a growing nexus between fiscal and monetary policies. Against this background, how can we safeguard central bank independence and credibility going forward?

First, fiscal sustainability should be assured, otherwise perceptions may arise that debt could be inflated away. Governments can start by 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 bank policies need to remain credibly focused on maintaining macroeconomic stability. Actions should remain in line with mandates, particularly price and financial stability. The intention behind policy actions should be clearly articulated and overt deficit financing avoided. Proper, institutional governance should be preserved. Wherever possible, indemnities of governments to cover potential central bank losses are extremely useful. Exit strategies should be articulated as soon as possible. Of course, an optimal exit is one that is induced by a favourable economic environment.

The bottom line is that there is a need to recognise the limits of monetary policy. Central banks cannot intervene in government debt markets on a large scale for any great length of time. Eventually, the natural boundaries between fiscal and monetary policy will need to be fully restored to preserve central bank credibility.

Finally, let me say that the aggressive measures described, crossing the traditional boundaries between fiscal and monetary policies, 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.