On Tuesday 29th September, the Keynes society welcomed Professor Andrea Ferrero for a talk about monetary policy. He spoke about how central banks have tried to respond to the Covid crisis and why unconventional and novel policies, such as buying private sector assets, have been necessary. Professor Ferrero, of Trinity College Oxford and formerly a Senior Economist within the Research Department of the Federal Reserve Bank of New York, is an expert on monetary policy, with a particular interest in the implications of unconventional monetary policies, and so was perfectly placed to deliver an engaging and informative talk on this subject.
The predominant theme of the talk was an overview of the rationale behind some of the astonishing policy moves of Western central banks around the world. Such policy moves have included the Fed lowering rates to an historic 0-0.25% and the Bank of England, ECB and Fed all expanding their QE programmes and even buying private corporate securities. The Fed, for example, has bought up $500 billion in Treasuries as part of its expansion of QE.
Professor Ferrero argued that the macroeconomic impact of Covid could be understood, at a simple level, through an IS-MP model, where the MP (monetary policy) curve is drawn as a horizontal line at the monetary policy rate set by the central bank. The effect of Covid may be displayed as an inward shift of the IS curve since job losses, lockdowns and precautionary saving have led to lower short term output at equivalent interest rates. Thus, the job of the central bank is to shift the MP curve down (i.e. lower interest rates) in order to maintain levels of short-term output (and also to boost inflation since, in a demand shock, inflation and output fall simultaneously).
Thus, it is easy to understand why central banks would want to cut interest rates during a demand shock: to raise output back to its long-run potential and return inflation to target levels. However, Professor Ferrero then went on to say that, in this crisis, lowering base rates has not, by itself, been sufficient to achieve this goal, which is why novel, alternative policies have been necessary. This is because, with interest rates already near zero pre-crisis, the optimal interest rate to encourage businesses to invest and households to spend may be substantially below zero, but central banks are reluctant to lower rates this far due to the threat of a ‘liquidity trap’.
Hence, as Professor Ferrero argued, central banks turned to alternative policies, such as forward guidance, asset purchases and liquidity, as a substitute for interest rate cuts: to simulate the effects of cutting base rates when cutting base rates is not a feasible option. Direct asset purchases also have the added effect of maintaining liquidity and access to funding for banks and companies since, if companies are struggling to raise funds, central banks may buy their debt directly. Another example Ferrero drew our attention to was the new inflation targeting policy of the Federal Reserve. In particular, the Federal Reserve has initiated ‘average inflation targeting’ which allows for even laxer policy during a recession, thus showing the Fed’s intention to keep policy very loose for the foreseeable future.
Overall, Professor Ferrero gave a full overview of the monetary policy responses of the Fed, ECB and BoE in response to the Covid-induced recession, as well as an introduction to the rationale and thinking behind central banks’ decisions. It was a perfectly-pitched talk from which everyone in attendance, no matter their prior knowledge level, learnt something and we thank Professor Ferrero for giving up his time and delivering this fantastic talk.