Mind the GAP(s): Monetary policy and the way out of the pandemic

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In 2020, the direction of policy support was evident due to the outbreak of the pandemic; monetary and fiscal policies supported the economy all around the world. But now we might be seeing the end of the pandemic thanks to the vaccine. So, are they still necessary in 2021? How can monetary policy relieve the economic consequences caused by Covid-19?

On Tuesday, March 2, 2021, Fabio Panetta gave a speech at an online event organized by Bocconi University. The member of the Executive Board of the ECB talked about how monetary policy support is essential to relieve the economic consequences caused by the pandemic. To read the full speech given by Mr. Panetta, you can click here. But, in case you are just looking for a quick recap on what was discussed, then you are in the right place.

Background on the problem

The progress made on vaccine technology has led us to believe that 2021 might be the year where the end of the pandemic is near. But it is important to keep in mind that, even if the pandemic is coming to an end, the economic consequences caused by it will still be present.

These economic consequences have opened two prominent gaps: the output gap and the inflation gap. And, if we fail to close them, we could hold back economic growth and depress inflation in the future. Deflation can be dangerous because it suggests an economy going through a recession. For this reason, macroeconomists suggest a low, yet present inflation rate between 0.7%-4%. Currently, the ECB is aiming for the inflation rate to be below but close to 2%. European inflation has met its target, averaging 1.7% inflation since the introduction of the Euro. In order to limit long term damage, we need to rely on policy support; by keeping nominal yields low for longer, we can preserve accommodative financing conditions which will lead to lower real rates and will help return inflation.

What are the risks we face?

We know that vaccination programs are ongoing in developed economies, and the second phase of lockdowns has been less costly than the first. This has made us take the beginning of the recovery from the economic crisis for granted, which may lead many to think that there is less need for monetary policy support. So, if the pandemic is coming to an end, why do we still need so many monetary policies? Mr. Panetta provides us with two reasons that call for further policy support in the European Union:

1. Macroeconomic policymakers should never rely on the most favorable scenario.

As said by the member of the executive board of the ECB himself, “The pandemic has produced an asymmetric balance of risks, which requires an asymmetric reaction function.” 

Even though we might believe recovery will likely happen at the end of this year, the risk of inflation being below the 2% aim is very high.

Additionally, one should bear in mind that the projected pre-pandemic recovery of economic activity set in 2022 still remains vulnerable. The near-term growth outlook is also skewed downward. The slow rollout of vaccines in the euro area, along with the new variants of the virus, are delaying the full reopening of the economy, and consumer and investor sentiment is likely to be depressed.

2. We still don’t know how strong the economic rebound will be once the economy will finally open.

We expect a temporary increase in spending on goods, but studies suggest that spending on services – which has been compressed- will be weaker. Plus, the distribution of income across households indicates a high saving rate throughout 2021.  The risks to private consumption growth are substantial.

The ECB’s projections show that the output gap in the euro area will not close before 2023. Boosting demand is necessary to reduce hysteresis risk after the pandemic. Low-skilled workers have been hugely affected, and lower business innovation and investment have negatively impacted productivity. Now, the challenge we face is:

How to deliver the necessary policy stance?

Monetary policy in the euro area has gone through three phase since the start of the pandemic:

1. First phase: flexibility of PEPP deflected a widening of spreads that obstructed monetary policy transmission
2. Second phase: PEPP helped steer the monetary policy stance; it loosened financing conditions and the TLTROs nailed down bank lending rates.
3. We are now entering the third phase, where we need to focus on lending rates and yield curve financial variables to guide us in the monetary policy stance.

The central bank needs to identify what level of nominal yields it is aiming to achieve to tailor its purchases and achieve that level.

What can we achieve?

Studies show that the ECB’s expansionary policies have been effective, and that without them, inflation and GDP growth would have been lower and unemployment higher.

But, because of the fall in the interest rate, monetary policy would work best paired with fiscal and structural policies. Together, they would help close the gap between saving and investment.

The ECB will continue net purchases under the PEPP until at least March 2022. The commitment to preserve favorable financing conditions should encourage governments not to underspend relative to the scale of the shock or withdraw fiscal stimulus too early. Fiscal policies are a key channel for transmitting monetary policy to the real economy. 

We could generate higher employment, investment and confidence in Europe by keeping demand policies expansionary until supply constraints appear and by lifting growth through NGEU-led investment and national reforms.

In order to achieve this, it is important to make the European economy more dynamic. The commitment of Member States to the NGEU is crucial to achieve this, because it ensures that spending generates growth-enhancing reforms that benefit all EU citizens.

“Harder, better, faster, stronger”

The main message can be concluded with the title of the song by Daft Punk:

As Fabio Panetta says: “The harder we push to close the output and inflation gaps, the better the outlook for the euro area economy. And the faster we get there, the stronger our growth potential will be.”