How Global Central Banks are Responding to COVID-19

When times get tough, central banks typically act as the first line of defense.

However, modern economies are incredibly complex—and calamities like the 2008 financial crisis have already pushed traditional policy tools to their limits. In response, some central banks have turned to newer, more unconventional strategies such as quantitative easing and negative interest rates to do their work.

In response to the COVID-19 pandemic, central banks are once again taking decisive action. To help us understand what’s being done, today’s infographic uses data from the International Monetary Fund (IMF) to compare the policy responses of 29 systemically important economies.

The Central Bank Toolkit

To begin, here are brief descriptions of each policy, which the IMF sorts into four categories:

1. Monetary Policies

Policies designed to control the money supply and promote stable economic growth.

2. External Policies

Policies designed to mitigate the effects of external economic shocks.

3. Financial Policies for Banks

Policies designed to support the banking system in times of distress.

4. Financial Policies for Borrowers

Policies designed to improve access to capital as well as provide relief for borrowers.

Putting Policies Into Practice

Let’s take a closer look at how these policy tools are being applied in the real world, particularly in the context of how central banks are battling the effects of the COVID-19 pandemic.

1. Monetary Policies

So far, many central banks have enacted expansionary monetary policies to boost slowing economies throughout the pandemic.

One widely used tool has been policy rate cuts, or cuts to interest rates. The theory behind rate cuts is relatively straightforward—a central bank places downward pressure on short-term interest rates, decreasing the overall cost of borrowing. This ideally stimulates business investment and consumer spending.

If short-term rates are already near zero, reducing them further may have little to no effect. For this reason, central banks have leaned on asset purchase schemes (quantitative easing) to place downward pressure on longer-term rates. This policy has been a cornerstone of the U.S. Federal Reserve’s (Fed) COVID-19 response, in which newly-created currency is used to buy hundreds of billions of dollars of assets such as government bonds.

When the media says the Fed is “printing money”, this is what they’re actually referring to.

2. External Policies

External policies were less relied upon by the systemically important central banks covered in today’s graphic.

That’s because foreign currency interventions, central bank operations designed to influence exchange rates, are typically used by developing economies only. This is likely due to the higher exchange rate volatility experienced by these types of economies.

For example, as investors flee emerging markets, Brazil has seen its exchange rate (BRL/USD) tumble 30% this year.

In an attempt to prevent further depreciation, the Central Bank of Brazil has used its foreign currency reserves to increase the supply of USD in the open market. These measures include purchases of $8.8B in USD-denominated Brazilian government bonds.

3. Financial Policies for Banks

Central banks are often tasked with regulating the commercial banking industry, meaning they have the authority to ease restrictions during economic crises.

One option is to ease the countercyclical capital buffer. During periods of economic growth (and increased lending), banks must accumulate reserves as a safety net for when the economy eventually contracts. Easing this restriction can allow them to increase their lending capacity.

Banks need to be in a position to continue financing households and corporates experiencing temporary difficulties.

—Andrea Enria, Chair of the ECB Supervisory Board

The European Central Bank (ECB) is a large proponent of these policies. In March, it also allowed its supervised banks to make use of their liquidity buffers—liquid assets held by a bank to protect against unexpected cash flow needs.

4. Financial Policies for Borrowers

Borrowers have also received significant support. In the U.S., government-sponsored mortgage companies Fannie Mae and Freddie Mac have announced several COVID-19 relief measures:

• Deferred payments for 12 months
• Late fees waived
• Suspended foreclosures and evictions for 60 days

The U.S. Fed has also created a number of facilities to support the flow of credit, including:

• Primary Market Corporate Credit Facility: Purchasing bonds directly from highly-rated corporations to help them sustain their operations.
• Main Street Lending: Purchasing new or expanded loans from small and mid-sized businesses. Businesses with up to 15,000 employees or up to $5B in annual revenue are eligible.
• Municipal Liquidity Facility: Purchasing short-term debt directly from state and municipal governments. Counties with at least 500,000 residents and cities with at least 250,000 residents are eligible.

Longer-term Implications

Central bank responses to COVID-19 have been wide-reaching, to say the least. Yet, some of these policies come at the cost of burgeoning debt-levels, and critics are alarmed.

In Europe, the ECB has come under scrutiny for its asset purchases since 2015. A ruling from Germany’s highest court labeled the program illegal, claiming it disadvantages German taxpayers (Germany makes larger contributions to the ECB than other member states). This ruling is not concerned with pandemic-related asset purchases, but it does present implications for future use.

The U.S. Fed, which runs a similar program, has seen its balance sheet swell to nearly $7 trillion since the outbreak. Implications include a growing reliance on the Fed to fund government programs, and the high difficulty associated with safely reducing these holdings.

The Fed’s Balance Sheet: The Other Exponential Curve

As the threat of COVID-19 keeps millions of Americans locked down at home, businesses and financial markets are suffering.

For example, a survey of small-business owners found that 51% did not believe they could survive the pandemic for longer than three months. At the same time, the S&P 500 posted its worst first-quarter on record.

In response to this havoc, the U.S. Federal Reserve (the Fed) is taking unprecedented steps to try and stabilize the economy. This includes a return to quantitative easing (QE), a controversial policy which involves adding more money into the banking system. To help us understand the implications of these actions, today’s chart illustrates the swelling balance sheet of the Fed.

How Does Quantitative Easing Work?

Expansionary monetary policies are used by central banks to foster economic growth by increasing the money supply and lowering interest rates. These mechanisms will, in theory, stimulate business investment as well as consumer spending.

However, in the current low interest-rate environment, the effectiveness of such policies is diminished. When short-term rates are already so close to zero, reducing them further will have little impact. To overcome this dilemma in 2008, central banks began experimenting with the unconventional monetary policy of QE to inject new money into the system by purchasing massive quantities of longer-term assets such as Treasury bonds.

These purchases are intended to increase the money supply while decreasing the supply of the longer-term assets. In theory, this should put upward pressure on these assets’ prices (due to less supply) and decrease their yield (interest rates have an inverse relationship with bond prices).

Navigating Uncharted Waters

QE falls under intense scrutiny due to a lack of empirical evidence so far.

Japan, known for its willingness to try unconventional monetary policies, was the first to try QE. Used to combat deflation in the early 2000s, Japan’s QE program was relatively small in scale, and saw mediocre results.

Fast forward to today, and QE is quickly becoming a cornerstone of the Fed’s policy toolkit. Over a span of just 12 years, QE programs have led to a Fed balance sheet of over $6 trillion, leaving some people with more questions than answers.

This is a big experiment. It’s something that’s never been done before.

Kevin Logan, Chief Economist at HSBC

Critics of QE cite several dangers associated with “printing” trillions of dollars. Increasing the money supply can drive high inflation (though this has yet to be seen), while exceedingly low interest rates can encourage abnormal levels of consumer and business debt.

On the other hand, proponents will maintain that QE1 was successful in mitigating the fallout of the 2008 financial crisis. Some studies have also concluded that QE programs have reduced the 10-year yield in the U.S. by roughly 1.2 percentage points, thus serving their intended purpose.

Central banks … have little doubt that QE does operate in many ways like conventional monetary policy.

Joseph E. Gagnon, Senior Fellow at the Peterson Institute for International Economics

Regardless of which side one takes, it’s clear there’s much more to learn about QE, especially in times of economic stress.

The Other Exponential Curve

When conducting QE, the securities the Fed buys make their way onto its balance sheet. Below we’ll look at how the Fed’s balance sheet has grown cumulatively with each iteration of QE:

• QE1: $2.3 Trillion in Assets
  The Fed’s first QE program ran from January 2009 to August 2010. The cornerstone of this program was the purchase of $1.25 trillion in mortgage-backed securities (MBS).
• QE2: $2.9 Trillion in Assets
  The second QE program ran from November 2010 to June 2011, and included purchases of $600B in longer-term Treasury securities.
• Operation Twist (Maturity Extension Program)
  To further decrease long-term rates, the Fed used the proceeds from its maturing short-term Treasury bills to purchase longer-term assets. These purchases, known as Operation Twist, did not expand the Fed’s balance sheet, and were concluded in December 2012.
• QE3: $4.5 Trillion in Assets
  Beginning in September 2012, the Fed began purchasing MBS at a rate of $40B/month. In January 2013, this was supplemented with the purchase of long-term Treasury securities at a rate of $45B/month. Both programs were concluded in October 2014.
• Balance Sheet Normalization Program: $3.7 Trillion in Assets
  The Fed began to wind-down its balance sheet in October 2017. Starting at an initial rate of $10B/month, the program called for a $10B/month increase every quarter, until a final reduction rate of $50B/month was reached.
• QE4: $6 Trillion and Counting
  In October 2019, the Fed began purchasing Treasury bills at a rate of $60B/month to ease liquidity issues in overnight lending markets. While not officially a QE program, these purchases still affect the Fed’s balance sheet.

After the COVID-19 pandemic hit U.S. shores, however, the Fed pulled out all the stops. It cut its target interest rate to zero for the first time ever, injected $1.5 trillion into the economy (with more stimulus to come), and reduced the overnight reserve requirement to zero.

Despite receiving little attention in the media, this third measure may be the most significant. For protection against bank runs, U.S. banks have historically been required to hold 10% of their liabilities in cash reserves. Under QE4, this requirement no longer stands.

No End in Sight

Now that the Fed is undertaking its most aggressive QE program yet, it’s a tough guess as to when equilibrium will return, if ever.

After nearly two years of draw-downs, Fed assets fell by just $0.7 trillion—in a matter of weeks, however, this progress was completely retraced.

QE4 is showing that what goes up, may not necessarily come down.