The COVID-19 Crisis and the Monetary Policy Response

Last week I joined my colleagues at the Governing Council (GC) of the European Central Bank for one of our regular monetary policy meetings. The GC is the ECB's main decision-making body and consists of the six members of the Executive Board and the 19 Governors of the central banks of the euro area countries. We set monetary policy for the euro area and our primary objective, as set out in the EU Treaties, is to safeguard price stability (which is an essential foundation of sustainable economic growth and job creation). We meet every six weeks to identify and offset risks that can undermine the successful delivery of our objective, undertaking an in-depth assessment of the macroeconomic environment and outlook, and deciding whether our policies are appropriate.

Last week our focus remained on Covid-19. The pandemic and the related containment measures are having a significant impact on economic activity in the euro area and across the globe. Survey-based indicators paint a dramatic picture. PMI readings in March and April show that the euro area is suffering from the steepest fall in business activity and employment that the survey has ever observed¹. The first estimate of euro area GDP growth for the first quarter of 2020 displays the sharpest decline ever recorded² although there is also broad consensus that growth will fall at an even sharper rate in the second quarter. Despite the very high uncertainty surrounding the ECB's staff projections, even the most benign scenario expects euro area real GDP to drop by around 5% in 2020. The staff's 'severe scenario' provides a dramatic – and in my view more plausible – outlook, with GDP expected to drop by around 15% on a quarterly basis in the second quarter of 2020, falling by around 12% over the whole year³.

Ireland is no exception to the European and global trend. On 2 April, our Quarterly Bulletin estimated that Irish real GDP could drop by around 8% in 2020 with the unemployment rate reaching a peak of around 25% in the second quarter of 2020, before declining to around 10.5% at the end of the year⁴. A month after we released those projections, the overall picture seems to have got even starker. Yesterday we published research⁵ that showed that approximately 620,000 people had been displaced from work as of end-April while a further 427,000 have received the government's temporary wage subsidy.

As I've written previously, I've always been sceptical about the prospects for a 'V-shaped' (i.e. swift) recovery once the worst of the crisis is over. It seems to me that consumer confidence will take time to return, particularly if a vaccine remains unavailable. The lifting of lockdown measures will be gradual to limit the risk of a second wave of the virus. Apart from the tragedy of further deaths, a second wave could have serious consequences for the already-weak confidence of markets, consumers and businesses.

And, whatever the timing and sequencing of the lifting of restrictions, it is reasonable to expect physical distancing to remain in place for some time. Embedding them into our economy will require important adjustments. The way people work and play and the way businesses respond to consumer demand will change, and such change will happen in ways that are not entirely predictable. Some businesses that have closed now may not re-open. Rigidities in product and labour markets will constrain a swift move of resources from sectors in lower demand to sectors in higher demand. Moreover, we would expect reductions in international trade and potential disruptions in global value chains, at least in the short/medium-term, some of it the consequence of the crisis but some also a result of policy choices by other countries. A small, open economy like Ireland is particularly sensitive to such developments.

Last week's GC meeting was not our first during the crisis. (One of the lessons we've all learned since the global financial crisis is the need for speed and decisiveness in responding to the crisis.⁶) The measures we announced on 12 and 18 March were aimed at supporting the smooth provision of credit to help households and firms through the significant uncertainty and disruption. They included a package (known as TLTRO-III) aimed at incentivising the provision of credit by banks to the real economy (reinforcing our current accommodative monetary policy stance.⁷ We also relaxed the collateral requirements for counterparties in credit operations, indicating a willingness to absorb risks from the private sector. On March 18, we launched the Pandemic Emergency Purchase Programme (PEPP), which provides additional monetary accommodation through a number of channels.⁸

The measures in March provide up to €3 trillion of liquidity at negative rates.⁹ They have helped maintain favourable financing conditions and support the flow of credit across the euro area.

Last week, we went further, lowering the interest rates in TLTRO III and announcing new pandemic emergency longer-term refinancing operations (PELTRO). In contrast to TLTRO, PELTRO is an unconditional liquidity facility and the interest rate does not depend on the behaviour of banks. Its objective is to provide liquidity support to the euro area financial system and contribute to preserving the smooth functioning of money markets by providing an effective backstop after the expiry of the bridge longer-term refinancing operations (LTROs) that have been conducted since March 2020.

Our actions have been timely and the tools we've used are targeted. (Other central banks across the world have similarly responded to the crisis by deploying various monetary policies that reflect their own particular circumstances, mandates and legal structures.) There are other tools available for us to ensure that our monetary policy remains effective. But some of those aren't well-targeted, or would be less effective or, quite simply, pose serious legal, political, operational and practical considerations that would hamper timely action. At the end of the day, we want to make sure that there is plenty of liquidity, that credit flows to the real economy, and that our monetary policy stance and transmission are effective in pursuit of our price stability objective.

Of course, monetary policy isn't the only game in town. Governments of euro area countries, including Ireland, have announced and implemented a series of important measures, aimed at supporting the immediate response to the virus as well as the workers and businesses that have been affected by the containment measures. It is essential that – throughout the euro area – fiscal support remains sufficiently strong and proportionate to the magnitude of the shock. We continue to need timely and targeted efforts by euro area governments to support the recovery.

At our next meeting, the GC will have more information available to inform our assessment of the macroeconomic outlook.¹⁰ Our focus will remain unchanged. We are determined to respond forcefully to the current challenges and to do whatever it takes to deliver our mandate of price stability, putting in place the necessary conditions to support households and firms through, and out of, the crisis.

Gabriel Makhlouf

¹ See last April's Markit PMI.

² See Eurostat's GDP preliminary flash estimate for the first quarter of 2020.

³ See ECB staff's scenarios for the economic impact of Covid-19 in the euro area.

⁴ April 2020's Quarterly Bulletin.

⁵ See Byrne et al in Economic Letters.

⁶ See former Governor Honohan's discussion about this.

⁷ For more details on the way that recent monetary policy actions, including the TLTROs, help firms and household in Ireland, see Holton et al in Economic Letters.

⁸ See the ECB explainer on the effects of asset purchases.

⁹ See President Lagarde's blog article.

¹⁰ See for example the European Commission's Spring forecast for Europe.

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