01 May 2020
The speed, depth and breadth of the coronavirus recession is unprecedented. Policymakers cannot avert the near-term pain. But they can limit the permanent scars from this crisis through bold and decisive action.
Containment measures aimed at curbing the advance of coronavirus are generating an economic shock far greater even that the 2008 financial crisis (see Chart 1).
Chart 1: A shock to US growth larger than anything seen in modern times
* Largest contractions in US q/q real GDP in every recession since WW2 – Q2 2020 is our information tracking forecast (%)
For global policymakers, this presents an unusual challenge. Although powerless to avert the short-term effects of social distancing, they can seek to mitigate household and corporate distress and provide a bridge for the economy. This will help activity to rebound when restrictions are lifted, thereby limiting long-term economic damage.
Governments and central banks have responded rapidly to the coronavirus shock. For instance, in the US, Congress has approved a massive stimulus package while the Federal Reserve (Fed) has slashed rates, provided huge liquidity injections, relaunched unlimited quantitative easing (QE) and eased lending criteria. More will follow.
Even so, our base case is that output and unemployment gaps will take years to close, leading to some permanent scarring of the economy. Worse, the risks seem to be tilted towards a deeper or longer downturn. These expectations imply the coronavirus crisis will put downward pressure on prices, adding to persistent undershoots in the Fed’s inflation target, and further denting its credibility.
So, how might policymakers support a more rapid rebound, lessen the economic scarring and avoid further downward pressure on inflation expectations? The world’s lacklustre recovery from the 2008 financial crisis casts doubt over the potency of the current policy toolkit. Relying on the current doctrine risks a decade of even lower growth, inflation and interest rates. A revolution in central bank thinking is required to avoid this outcome.
Central banks and governments could start by co-ordinating their policies and pushing in the same direction. History shows the two bodies have often worked at cross-purposes. As soon as an economy looks to be picking up in response to government stimulus, central banks have tended to raise rates to prevent overheating. On the flip side, after the financial crisis, the government was too quick to reverse its stimulus efforts, leaving all the weight to fall on the Fed.
In the current environment, it would make more sense for the central bank to leave rates low in response to a prolonged government stimulus. Indeed, research indicates that a co-ordinated policy approach makes government spending or tax cuts far more effective weapons to fight economic inertia.
The next level of co-ordination could see the central bank helping the government finance its stimulus plans. This occurs when the central bank purchases all, or a big part of, newly issued government debt. This frees up private sector capital for other uses and keeps interest rates lower. It makes it easier for the government to both raise finance and to keep its borrowing costs down.
However, crucially, there is no direct policy rule or agreement between the central bank and government treasury stipulating the conditions under which these purchases occur. They are conducted solely at the discretion of the central bank and calibrated to allow it to meet its standard objectives and ensure the financial system operates smoothly.
The action just described mirrors current US policy. Some have labelled it as ‘helicopter money’ or monetary financing of the government’s stimulus plan.
But two features are critical for it to meet the definition of helicopter money. First, the cash would be distributed to households and businesses directly, rather than through the banking system. Second, these sums would be funded by a permanent increase in the money supply and do not need to be repaid. It’s hard to see how such a policy could fail to stimulate demand and/or increase prices.
This means that current US policy is nothing like helicopter money. In reality, it’s plain old QE and credit easing, albeit on an enlarged scale.
True helicopter money – the direct and permanent financing of government spending – would generate more powerful effects. It would directly boost activity through government spending and raise inflation expectations due to a permanent increase in the money supply. Moreover, it would never need to be repaid in the future through higher taxes or spending cuts.
This sounds radical, but there are ways the Fed could add helicopter drops to its policy toolkit. Indeed, this could work well in conjunction with a shift towards price or growth targets that allow for periods of higher inflation.
One impediment to this bold action is concern that providing helicopter money would ultimately rob the central bank of its independence, and lead to monetary policy becoming subservient to government (fiscal) policy. The central bank would become little more than a funding resource for government spending plans.
Yet, ironically, we would argue the best way for the central bank to keep its independence is by issuing helicopter money on its own terms. By doing nothing, the Fed risks damaging its credibility, eventually making fiscal dominance (where the government essentially controls the central bank) more likely.
This loss of independence could occur passively, as central banks get trapped in a low-growth and low-inflation environment and are forced to take on ever increasing quantities of public debt as part of their temporary QE programs. This would leave the central bank with no credible means of offloading this debt, making it effectively a tool for financial repression.
Alternatively, the government could implicitly or explicitly revoke the central bank’s independence. It might do so in response to poor economic performance or a desire for central bank policy to accommodate politically motivated government spending. This would greatly increase the risk of a disruptive surge in inflation and large swings in economic activity.
The central bank’s policies must be radical enough to restart economic growth but not to the extent it relinquishes independence - helicopter money may be the answer.
The central bank’s policies must be radical enough to jolt the economy back to its pre-crisis growth path but not to the extent that it relinquishes independence, passively or otherwise. Helicopter money may well provide the answer.
There are several ways the Fed could issue helicopter money. One option is a more direct route that avoids the need to issue bonds or other securities. It would involve creating a government treasury account at the Fed. The Fed would credit the account with an agreed sum for the government to spend as it sees fit. This approach is likely to be highly effective in stimulating the economy. As part of this step, the Fed could announce an intention to allow inflation to run stronger in the short term, helping to make up for previous undershoots of its inflation target.
Yet, we fear the most likely outcome is that the Fed just pushes harder on its existing toolkit, rather than seeking new solutions to this crisis. For example, it might extend the period of lower rates and unlimited QE. While not ineffectual, these policies will probably not be enough to prevent long-term economic damage.
In this scenario, we should expect a slower recovery, even lower inflation and entrenched low interest rates. This would deal another blow to central banks’ credibility and, ultimately, jeopardise their independence.
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