Opinion & Analysis

Policy Insight | What can the ECB achieve in a lockdown recession?

The honest answer is, very little.

The economy of the euro area might well chalk up another quarter of negative growth in Q1 2021 as governments are prolonging social distancing measures due to the continuing winter wave and the slow pace of vaccination.

While the euro area economy remains weak, the US economy is poised to accelerate. A number of short-term indicators point to double-digit growth in the near term and stronger medium-term growth as lockdowns are lifted and US consumers start spending their accumulated savings, supported by further transfers from the $1.9 trillion package instigated by President Biden.

In this context, it is not surprising that US long-term rates have increased, already returning to their pre-Covid level.  Given the global nature of capital markets, rates in the euro area have also increased.  The benchmark German bond yield has risen by 20 basis points – hardly a major move, even though the ECB has felt it necessary to declare its willingness to increase the pace of its bond buying to support the economy.

But what could the ECB hope to achieve? It should not react to a recession in the usual way because this one is different, certainly very different from the last one.

There is broad agreement that lockdowns should be considered as a mixture of sectoral supply and demand shocks that directly affect travel, tourism and other contact-intensive services such as restaurants. These shocks are then transmitted via input-output linkages across sectors, which propagate these sectoral shocks (both demand and supply) to the entire economy.

A key consequence of the sectoral and externally imposed nature of these shocks is that attempts to stimulate aggregate demand have little impact on the overall economy as long as the sectoral restrictions of the lockdowns persist.

As an example, Farhi and Baqaee (2020) study supply and demand shocks in a general disaggregated model with multiple sectors. They conclude that “aggregate demand stimulus is only about a third as effective as in a typical recession”. This finding applies to monetary policy, in particular because monetary policy can only attempt to stimulate aggregate demand. In contrast to fiscal policy, it cannot be targeted at those sectors in which demand or supply are affected by the lockdown.

Lowering interest rates via monetary policy instruments is usually thought to induce households to bring consumption forward, to consume more today and less tomorrow. However, this mechanism works less well when households today cannot afford their normal consumption basket.

A concrete example can illustrate this proposition. Consider a person who wants to buy new sports equipment to be used on a vacation abroad. Normally, a low interest rate would make it more likely that the entire consumption basket (e.g. vacation and sports equipment) is bought today. But if foreign travel is impossible today due to the pandemic, the sports equipment will not be bought. No amount of interest rate reductions will lead to higher sales.

The evidence for the differences across sectors is already clear at the level of large aggregates, such as services and manufacturing. Figure 1 below shows the confidence indicator for these two macro sectors. In 2020 manufacturing confidence fell much more and was quicker to rebound than services. At present, in early 2021, manufacturing confidence is at a high level and industrial output is indeed expanding. However, confidence in services is much lower and declining again under the impact of the lockdowns imposed in late 2020. The difference between the two has reached an unprecedented level.

Figure 1. Eurozone Purchasing Managers Index (PMI) – 2018-21

Another piece of evidence for the reduced effectiveness of monetary policy is the fact that since the start of the crisis households have chosen to save a large part of their income. Figure 2 shows that household savings rates have more than doubled – not driven by interest rates, but by the fact that many services cannot be bought today. The aggregate data on household savings of course hide big differences in incomes across occupations. But these sectoral issues can only be addressed by fiscal, not monetary policy.

Figure 2. Household savings rates in the four largest euro area countries

The impact of lockdowns on spending is compounded by uncertainty about the course of the disease, with no end in sight as long as vaccination remains woefully behind schedule in the EU. This uncertainty also holds back investment in sectors such as hospitality if it is not clear when these sectors can reopen.

The conclusion is simple: monetary policy becomes ineffective in a recession that is caused by government-imposed lockdown. The minor reductions in interest rates that the ECB might hope to engineer by tweaking the asset purchases under the pandemic emergency purchase programme (PEPP) cannot have a significant impact on the sectors that are locked down. The rest of the economy is expanding anyway.

Finally, one should keep in mind that temporary variations in the pace of asset purchases within the given overall volume of the PEPP can at most have a second-order effect on interest rates.

Tweaking the path of bond purchases is thus unlikely to have a meaningful impact on the ultimate goal of the ECB, namely price stability. The ECB should keep its powder dry for the ‘day after’. Once the lockdowns have ended for good, monetary policy can once again become effective.

This Commentary draws on: A. Capolongo and D. Gros, (2020) “This Time is Different: The PEPP Might Not Work in a Sectoral Recession”, contribution to the Preparation of the European Parliament, Monetary Dialogue, and D. Gros and F. Shamsfakhr (2021) “Adjusting Support in a K-Shaped Recovery”.


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