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Photographer: Stefani Reynolds/Bloomberg
New Economy

How the Covid Crisis Calls for a Makeover at the Fed and ECB

How the Covid Crisis Calls for a Makeover at the Fed and ECB

Senate Returns After Biden's Victory In 2020 Presidential Race
Photographer: Stefani Reynolds/Bloomberg

In his first year in office U.S. President-elect Joe Biden has an opportunity to remake the leadership of the Federal Reserve: the current terms of Chairman Jerome Powell and both his two vice chairs expire by 2022. But what the Fed and other central banks need most in a post-Covid world is not new leadership, but a fresh understanding of what they were put on this Earth to do.

Mohamed El-Erian, chief economic adviser at Allianz SE, famously dubbed central banks “the only game in town.” They emerged out of the 2008-09 global financial crisis as seemingly the world’s only effective bulwark against economic disaster. We can see how the world has come to rely on central banks by the recent discussion of their potential role in combating climate change. If you want to get something done these days, you ask a central bank.

This reliance on monetary policy has had two related side effects: it has tested central bankers’ policy repertoire to the limit, and focused more attention on the way that monetary policy may have impacted income inequality and the efficiency of the economy. In thinking about how the standard toolkit could be expanded, recent official debates about the future of monetary policy have responded to the first of these. But the second set of issues is just as important — and arguably even more urgent.

To see why, take a look at what the Fed’s recently completed review has, and has not achieved.

It set out to confront several interrelated facts about the current environment that have made it more difficult for many central banks to do their job. First, extremely low real long-term interest rates, which predate the global financial crisis and relate to structural shifts in the demand and supply of investment funds, which central banks can’t directly control. Second, a much weaker relationship between rates of unemployment and wage inflation in advanced economies, such that even when unemployment has fallen significantly, inflation hasn’t picked up.

Zero Lower Bound

The upshot of these two factors has forced central banks to operate increasingly at the “zero lower bound” — unable to cut policy rates further and struggling to push real short-term interest rates down.

In such an environment, the Fed has rightly been concerned that a symmetrical 2% inflation target will tend to have an asymmetrical outcome. Knowing that the central bank has more capacity to bring prices down from above target than they have to lift them up from below target, businesses and consumers will rightly expect inflation to average somewhat below where it’s meant to be. The risk is that these sub-2% expectations become self-fulfilling and inflation over time will chronically undershoot.

This is a significant problem. Repeatedly falling short of target is bad for the central bank’s credibility as well as for the economy. We would all pay a price if the gradual wearing away of central banks’ credibility makes it progressively harder for them to do their job.

Helping the Rich Get Richer

But if you asked any reasonably engaged European or U.S. citizen what they found worrying about their central bank’s recent policies, I doubt that failing to prevent a downward shift in long-term inflationary expectations would be top of the list. More likely, they would point in one way or another to the collateral impact on financial markets of super loose monetary policy: how it had contributed to excessive risk-taking in many asset markets, for example, and possibly underwritten a big increase in the wealth of the already well-off.

Public comments by Powell and his fellow policy makers at the Fed this summer, in the wake of the Black Lives Matter protests, suggest they understand how costly it could be for the central bank if large chunks of the population come to believe that the Fed isn’t making policy on their behalf.

When the Fed began raising interest rates in 2015 to guard against the possibility of inflation, White unemployment was at 4.4% while the Black jobless rate stood at 8.5%. The Fed can’t directly control racial disparities in wages and unemployment. But, as my colleague Andrew Husby has shown, the amended rule that has come out of the policy review would give it more scope to take these differences into account.

Fed’s Employment Mandate

Although most have focused on the move to flexible inflation targeting, the change in the Fed’s messaging around the employment part of its mandate is arguably more important. By promising to avoid not deviations from full employment, but persistent shortfalls relative to full employment, the Fed is telegraphing that it won’t in the future consider very low unemployment, by itself, to be a problem. To many outside the Fed, this will seem a statement of the obvious, but it’s welcome all the same.

So the U.S. central bank has made some progress in 2020, not just in updating its approach to inflation but strengthening its claim to serve all Americans. But the reality is that its reliance on quantitative easing and forward guidance of interest rates will still leave it extremely dependent on asset markets to transmit future policy.

In effect, all that new language implies is that the Fed will continue stoking asset prices — and wealth inequality — for as long as it takes for the poorest in society to benefit. That might seem a very modest step in the right direction for many critics, and one with significant costs attached. It would, however, be a revolution for central banks such as the ECB, which has traditionally defined its mandate narrowly around the single goal of stable prices.

Impact of Covid-19 Crisis

One could argue that Covid-19 has produced a partial antidote to the over-reliance on central banks, in the form of extreme fiscal policy. The International Monetary Fund expects gross public debt ratios to rise by more than 20 percentage points between 2019 and 2021 in the U.S. and U.K. and by about 16 percentage points, on average, across the euro zone.

But as Bloomberg economists Jamie Rush and David Powell point out, this surge in public borrowing would not have been possible without central banks printing money. Bank of England Governor Andrew Bailey has said the U.K. government “would have struggled to fund itself” in March without central bank support. Central bank liquidity was equally crucial to maintaining calm in U.S. and European bond markets. In that sense, fiscal policy didn’t replace extreme monetary policy support — it just spent it.

Central Banks to Finance Increased Government Spending

relates to How the Covid Crisis Calls for a Makeover at the Fed and ECB
Source: Bloomberg Economics


How you feel about this development will depend largely on what you least like about monetary policy at the zero lower bound. If it’s the distributional consequences that concern you, you might tentatively welcome the fact that central banks are now bankrolling fiscal stimulus, along with higher stock prices and cheap corporate borrowing.

In theory at least, government fiscal stimulus to households and businesses ought to be more equitably distributed than the gains from higher asset prices. Although, if the counterpart of the increased government borrowing (and increased central bank liquidity) has been a dramatic rise in private savings, even that result is not entirely clear. U.S. census data suggests that the wealth of the top 10% of U.S. households rose by an extraordinary $5.6 trillion in the second quarter of 2020 as a result of the buoyant stock market.

Central Bank Independence

If, on the other hand, threats to central banks’ independence keep you up at night, you may think the Covid-19 crisis has taken them several steps closer to hell. If and when inflation reappears, it’s reasonable to ask whether central banks will be quite as keen to raise interest rates, if it puts the fiscal sustainability of national governments at risk.

Understandably, central banks are keen to maintain “constructive ambiguity” on the question of how they would make these future trade-offs. In a sense, they want the benefits of fiscal dominance — a willing partner in the battle to support the economy — without the reputational costs. But it isn’t clear this is going to be sustainable in a world where ambiguous positions by policy makers tend to receive short shrift.

Quite likely, the world would be better off in the long term if central banks retain their independence. To make this middle ground sustainable, however, these institutions probably need to sign up to a broader conception of what they are here for. This would be not just achieving low inflation but enabling the state — broadly conceived — to deliver better outcomes for people in a world where productivity and interest rates seem structurally low.

It may feel like a big conceptual leap. But whether it’s the ECB’s negative rates, or the Fed’s purchases of junk bonds, the day-to-day practice of monetary policy has changed beyond recognition in most major advanced economies over the past 10-15 years. Recasting their broader mandate to better reflect the complex challenges and pressures of this new environment won’t be easy. But now would be a very good time to start.