The monetary policy response by three of the world’s major central banks – the Bank of England, the European Central Bank and the US Federal Reserve – has contributed significantly to mitigating the economic consequences of the global pandemic.
The fiscal response to the Covid-19 health emergency has attracted a lot of attention (discussions of fiscal policy on this website cover the fiscal impact of the crisis, the size of the fiscal multiplier and what it means for the future role of the state in the UK). But central banks, which did so much in response to the global financial crisis a decade ago, have also taken action to try to mitigate the severity of the recession.
The comparative analysis in this article highlights the many similarities and a few differences in the monetary policy responses to the Covid-19 crisis by three of the world’s major central banks: the Bank of England (often known simply as ‘the Bank’), the European Central Bank (the ECB) and the US Federal Reserve (‘the Fed’).
Did all three central banks lower their main policy interest rate?
Widespread job losses and delayed investments associated with the pandemic and the lockdown policies slowed down demand during the Covid-19 crisis. Interest rate cuts constitute the textbook monetary policy response to negative aggregate demand shocks (Jones, 2020).
In line with this view, the Bank of England reduced the Bank Rate by 65 basis points, bringing it to 0.10%. Similarly, the Fed decreased the Federal Funds Rate by 100 basis points to 0-0.25%.
Conversely, the ECB kept its reference rate (the Deposit Facility Rate) unchanged at -0.50%. The ECB’s chief economist justified this choice with the expected temporary nature of the Covid-19 shock (Lane, 2020). The ECB’s decision may also reflect the concern that negative interest rates are a relatively untested policy and pushing interest rates further down into negative territory could excessively hurt commercial banks’ profitability.
What else did the three central banks promise?
In the aftermath of the 2008/09 global financial crisis, central banks started to rely systematically on ‘forward guidance’ – a conditional commitment about the evolution of the policy rate in the future – as an additional policy tool. The idea is to provide monetary policy accommodation by influencing the private sector’s expectations of future policies when the short-term interest rate is constrained by its effective lower bound (Woodford, 2013).
The ECB monetary policy statements have kept the explicit references to future rates and asset purchases that were already in place before the Covid-19 crisis started. The main change has been that the language now explicitly links the conditionality to health developments.
The Fed is currently pursuing a similar strategy, having reintroduced forward guidance in March when the health situation started to deteriorate in the United States. Unlike the post-financial crisis period, however, the Fed language has remained rather general, with no explicit reference to particular levels of inflation and/or unemployment beyond which the Fed may decide to reconsider its commitment.
Acting differently from the other two central banks, the Bank of England has so far not adopted forward guidance in the current circumstances. With the Bank Rate near zero, this decision is somewhat surprising and may reflect the unfortunate experience of the second half of 2013.
At that time, the Bank of England conditioned its commitment to keep rates at 0.5% until unemployment had reached 7%. While the Bank had expected unemployment to remain high for several months, the data quickly came in much better than expected. By January 2014, unemployment had already fallen below 7%, thus undermining the impact of the Bank’s commitment.
Which assets have the three central banks been buying?
Even when the main policy interest rate is at, or slightly below, zero, central banks can still lower the cost of borrowing using ‘quantitative easing’ (QE, as explained here). Purchases of long-term government securities bid up their price and thus reduce their yield. Market forces should then contribute to passing the lower cost of funding through to the private sector, above and beyond the effect of the short-term policy rate (Bank of England, 2020). This can help to sustain the flow of credit to households and firms, and thus ultimately boost aggregate demand.
The Bank of England, the ECB and the Fed have each reinforced existing asset purchase programmes as well as creating new ones. In particular, the ECB has increased its QE programme by €120 billion and has started a Pandemic Emergency Purchase Programme (PEPP) of €1,350 billion. At the same time, the ECB has also expanded the range of private assets that it can purchase from non-financial institutions through the Corporate Sector Purchase Programme, thus providing further liquidity directly to the productive sector.
The Bank of England’s intervention has been similar. The Bank aims to buy gilts worth £435 billion and private assets worth £10 billion, while also buying assets on the primary market from companies that are considered vital for the UK economy.
The Fed has restarted its QE programme, committing to buy $500 billion in Treasuries during the coming months and $200 billion in mortgage-backed securities guaranteed by the government. The Fed has also been active in the corporate sector, by purchasing corporate securities on both the primary and secondary markets through the Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility, respectively. Finally, the US central bank has launched a programme of direct business loans characterised by soft payment terms, with the objective of guaranteeing wide liquidity margins and avoiding defaults.
Related question: 'Monetary financing': is it happening and what are the dangers?
What support are the three central banks providing directly for the financial system?
Liquidity injections, which make cash available to financial institutions, are a fundamental tool for managing the early stages of systemic episodes. The practice dates back to 1873 and the so-called ‘Bagehot doctrine,’ according to which the lender of last resort should lend first, to solvent entities; second, at a discount; and third, against good quality collateral (Tucker, 2009).
The basic idea is that uncertainty in an economic crisis can create debt refinancing problems, especially in the short term. Private operators become particularly risk-averse and unwilling to offer loans to other institutions. The central bank can limit the negative effects of this situation by operating as a lender of last resort and taking liquidity risk onto its balance sheet.
This type of operation typically takes place through the so-called ‘discount window,’ which banks can access because of their role as primary dealers. But the discount window may carry a ‘stigma’ effect – that is, sending a signal that the bank requesting the loan is in financial troubles. As a result, other banks may decide to call in their loans in the interbank market (or not grant new ones), thus escalating a temporary liquidity shortage into a full-blown insolvency crisis. On a large scale, this type of crisis can threaten the survival of the entire banking system, as the bankruptcy of Lehman Brothers in September 2008 showed.
In response to this problem, central banks have complemented discount window lending with direct purchases of private securities in secondary markets. One of the most important developments of the Covid-19 crisis, which draws a parallel with the 2008/09 crisis, is that central banks have also decided to purchase securities issued by non-financial companies, therefore providing liquidity not only to the financial system, but also directly to the productive sector.
Our three major central banks have adopted similar liquidity measures – an increase in the volume of loans and a softening of the existing terms. The ECB has expanded its non-targeted long-term refinancing operations (LTRO). Starting in June 2020, a similar programme specifically aimed at supporting small and medium-sized enterprises – the Targeted Long-Term Refinancing Operations (TLTRO) III – has been conducted on more favourable terms – that is, with a negative interest rate that is decreasing in the amount of loans, so as to encourage their use.
Similarly, the Bank of England has implemented a programme of loans to financial institutions to assist the transmission of conventional monetary policy measures, preventing the lowering of interest rates from having a negative impact on the amount of loans granted to households and businesses. This programme, called the Term Funding Scheme, provides long-term loans (four years) to banks and further liquidity provision for banks that increase the amount of credit to small and medium-sized enterprises.
Finally, the Fed has lowered the interest rate applied to bank loans from the discount window to 0.25%, which is below the level reached during the crisis of 2008/09. Although the loans are not as long-term as those offered by the ECB, the Fed has increased the loans’ duration from one to 90 days.
Did central banks coordinate their actions?
Starting with the shutdown of money markets following the September 2001 terrorist attacks in the United States, and continuing with the financial turmoil of 2008/09, recent crisis episodes have witnessed a number of coordinated central bank interventions to avoid funding strains among financial institutions.
Given the prominent role of the US dollar in the global financial system, the most notable example of these actions has taken the form of currency swap lines between the Fed and other central banks. In practice, the Fed and a foreign central bank agree to exchange US dollars for local currency at a given exchange rate and maturity. This way, foreign central banks can have access to the necessary liquidity in US dollar terms at a pre-determined exchange rate without the potential pressures and the uncertainty associated with the evolution of a crisis (Bahaj and Reis, 2020).
At the beginning of the Covid-19 crisis, the Fed had outstanding swap lines in place with the Bank of England and the ECB (in addition to the Bank of Canada, the Bank of Japan and the Swiss National Bank).
Data from the Federal Reserve Bank of New York’s website give a sense of the use of swap lines during the pandemic. Between mid-March and the end of July 2020, the Bank of England accessed the swap lines 31 times for a total amount of $91.9 billion. The settlement term was seven days for 26 operations and 84 for the remaining five. During the same period, the ECB total dollar uptake amounted to $268.2 billion. The settlement term was seven days for 51 of the 76 operations, 84 days in 19 cases, and either six, eight or ten days in the remaining instances. While the Bank of England has not accessed the swap lines since mid-June, the ECB continued to exchange euros for dollars through at least July 2020.
The response of monetary policy to the Covid-19 crisis has consisted of several measures with the aim of ensuring the flow of credit to the real economy and the proper functioning of the monetary policy transmission mechanism. These objectives translate into the concrete creation of incentives for banks to continue lending to families and businesses, despite the difficult economic situation.
Our comparative analysis suggests a high degree of accordance in the actions of three of the world’s major central banks. While a full assessment would require more formal analysis, based on previous episodes, in particular on the response to the 2008/09 global financial crisis, we tentatively conclude that the monetary policy response has significantly contributed to mitigating the economic consequences of the global pandemic.
Where can I find out more?
Forward guidance by inflation-targeting central banks: A 2013 study by monetary policy theorist Michael Woodford.
What is quantitative easing? An explanation by the Bank of England published in 2020.
The monetary policy package: an analytical framework: A summary of the ECB’s response by its chief economist Philip Lane.
The repertoire of official sector interventions in the financial system: last resort lending, market-making, and capital: A speech at the Bank of Japan 2009 International Conference by then Bank of England deputy governor Paul Tucker.
Central bank swap lines during the Covid-19 pandemic: Saleem Bahaj and Ricardo Reis writing in Covid Economics: Vetted and Real-time Papers.
In conversation with Mervyn King: Jagjit Chadha, Director of NIESR and a lead editor of the Economics Observatory, interviewed former Governor of the Bank of England Mervyn King on radical uncertainty, coronavirus, and economic policy.
Who are experts on this question?
- Andrea Ferrero
- Simona Giglioli
- Silvana Tenreyro
- Ricardo Reis
- Michael McMahon
- Charles Goodhart
- Jagjit Chadha