Monetary policy, in its traditional form, has been taken for granted over the past few decades, with central banks relying heavily upon the monetary transmission mechanism to steer the direction of the demand side. Since 2008, we have had to fundamentally rethink the interest rate mechanism as rates remain near 0 across most developed economies, removing any leeway to take them down further. The COVID-19 pandemic has demonstrated just how little firing power the banks have left, so we need to focus on alternative methods to sustain the economy, carefully considering the possible consequences.
The challenges of COVID-19
Pre-2008 was a much simpler time for central banks, with rates lowered in times of trouble or falls in confidence to encourage spending rather than saving, and raised only if there were signs that the economy was operating beyond its full capacity. However, in the financial crisis of 2008, rates internationally were being slashed to below 1%, and have remained at that level since, as the global economy remained fragile during the subsequent recovery. Many were sceptical of how we would respond to a recession of similar scale, as it would be impossible to cut rates by multiple percentage points again (the UK did by 4 percentage points over five months in 2008), but those worries were generally put aside as the new convention of quantitative easing (QE) was explored, offering some degree of hope. The COVID-19 pandemic has been a huge test for banks, with rates being cut 164 times in 147 days which rapidly exhausted the potential use of any further cuts, leaving monetary decision makers trying to keep demand afloat using unconventional methods.
The global response
Rates reached 0.1% in the UK, 0.25% in the US, and 0% in the Eurozone, with many more economies around the same mark. The Bank of England has made it very clear that it is considering the implementation of negative rates and wants high street banks to be prepared for this possibility, perhaps illustrating the growing acceptance that this could become reality. This is by no means enough to prevent the economy stalling, as they know, which has led to the adaptation and expansion of new policies, most notably the expansion of QE programmes to decrease the long-term rate of interest through a similar mechanism, with the level reaching £200bn in March 2020. This works by the central bank creating digital money to repurchase government bonds (usually) in order to increase spending and investment. The Federal Reserve has led this response in regard to size, with the latest round reaching $700bn. Another strategy complementing this is the new forward guidance policy, where central banks commit to keeping rates low for a given period of time into the future in order to stimulate consumer and business confidence, trying to shift the rational move away from excessive saving.
Dependency on fiscal policy
Apart from this, there is very little central banks have the ability to do; rather, the responsibility is increasingly falling on the fiscal side. We are having to rely upon politicians to take the lead and pass large stimulus bills in order to prevent economies faltering, which can prove rather troubling due to the complexity of the political system relative to central banks. The US Stimulus Bill, for example, has been delayed by a great deal of time due to the inability of Democrats and Republicans to settle on an agreed figure, leaving the American people to suffer in the meantime as their standard of living dwindles. In the UK, we have seen Rishi Sunak step up to the task by offering multiple loans and a furlough scheme estimated to cost £69bn to replace workers’ wages during the lockdown, as well as creative Keynesian policies such as the “Eat Out to Help Out”. It has been slightly more challenging for the Eurozone, as there isn’t the presence of a fiscal union to ensure all states complement the monetary policy, which is unlikely to change without challenging individual nations’ sovereignty. One of the lessons learnt from this pandemic is that we have seen politicians begin to embrace the “whatever it takes” attitude to keeping economic activity running, with historically large budget deficits contrasting the more austere approach post-2008, as we begin to realise this is one of our few remaining options.
The dangers of this approach
There are, of course, dangerous consequences attached to these new unconventional methods associated with near negative rates, which, if ignored, could create a variety of new socioeconomic issues. One of the main criticisms has been the impact on inequality, with QE programmes leading to a rise in asset prices, making the wealthy even more well off and potentially reducing social mobility as various assets become ever more unaffordable (e.g. the housing market). In addition, those relying heavily on savings will suffer as they lose a significant proportion of income from interest, which most affects the elderly demographic who have retired, and perhaps worsening the dependency issues faced by developed nations. Others argue that we will risk the credit supply drying up as it becomes increasingly unprofitable for banks to lend, though we could possibly see central banks step in to prevent this. Not only will we face the impacts, but those in developing countries are likely to suffer with us as capital inflows into their countries seeking a higher rate of return lead to a reduction in the competitiveness of their exports as the currency appreciates.
Though there are many risks associated with this approach of keeping rates so low and pushing into the negative territory, we shouldn’t be afraid to try out this approach, simply due to the lack of alternatives. Otherwise, we risk the health of the economy and a diminished standard of living for many. COVID-19 has been a real test for central banks, and most have succeeded in doing all they can and pressuring governments for fiscal action. We cannot stop the process of economic decline, with a second wave and lockdown in sight, so these arising policy issues would be best tackled by government initiatives to provide alternatives for savers and increase social and class mobility, and directly tackle the other problems to make the process as unproblematic as possible. We have entered a new era of monetary policy as interest rates become almost redundant, and now more than ever, we need to commit to finding sustainable alternatives to ensure a prosperous future for us all.