Should central banks continue to rely on Quantitative Easing to combat the economic effects of Covid

One of the most important functions of any central bank is to manage the country's liquidity and ensure Interest rate stability. Central banks have been using Quantitative Easing (QE) as a tool to inject liquidity into their economy. This could be done by buying government bonds and / for other financial assets. With high demand for these instruments, the interest rates or 'yields' on these bonds fall leading to reduction in interest rates. Easy liquidity makes it cheaper for households and companies to borrow money. On the retail side the household expenses go up because of leveraged spending.

Given the sudden halt of economic activity due to Covid-19 crisis, there was an unprecedented drop in economic activities. To push start the economy, the governments were working together with Central banks to pump in large amounts of money through this measure. Now, if massively increased, the money supply leads to inevitable inflation. However, QE does two things that foster recovery: it ensures market liquidity and it promotes confidence in the financial system. This ensures that there is enough money available to lend, spend, and save. QE ultimately helps to stabilize asset pricing in the short run. That is exactly what QE did for the US economy from 23 March-3 April 2020. In terms of equities, the Dow Jones Industrial Average (DJIA) and Standard and Poor's 500 (S&P 500) both had two-week rallies of more than 14% from panic lows. With the Equity market showing a bull run, in terms of currency, the United States dollar (USD) became a preferred safe-haven asset among investors. From 23 March to 3 April, most major forex pairs traded within established ranges with USD showing some appreciation.

QE has some detractors too. Although it was credited with turning the tides of the 2008 financial crisis, critics contend that its positive effects are temporary and that QE poses major risks to the morality of government, currency stability, and the future course of monetary policy. Liquidity given also needs to come back.

As an alternative, such regulatory forbearance could well be supplemented by credit easing (CE). CE has been both the Fed’s and the ECB’s main policy innovation in the pandemic. In other economies, such as India, the government has set up funds to purchase short-term commercial papers of non-financial corporates that were facing liquidity issues. However, whether undertaken by the central bank or the government, such interventions are never easy to implement. Most do not have a framework in place to assess risk and as a result are not able to price bonds efficiently. While capital loss should not be a concern for central banks as it does not impede any of its functions, the optics of running losses could well erode public faith and credibility. Of course, the fear of capital loss is a concern for governments for whom these are contingent liabilities and impact debt sustainability. It is also a testimony to increased acceptance

of unconventional interest rate policy and QE as appropriate responses once calibrated to the depth of the growth shock. As markets have calmed, central banks have also dialed down QE. The pause has reinforced our long-held view that central banks will use QE as an extraordinary measure and not provide governments a way to abandon fiscal discipline, as the market feared. As with QE, the authorities will need to work overtime to convince the markets that the unorthodoxy will be limited and time-bound. According to the head of the Bank of England, ‘the pace of QE purchases may be more important during a period of market dysfunction associated with a widespread shock to liquidity demand. ‘Going Big and Fast’ with QE is particularly effective in these conditions’. Therefore, policy needs to provide the time and space for the economy to recover and repair balance sheets. This is why QE (limited and time-bound) is justified even though policy rates in many countries are still substantially above zero.

Should central banks continue to rely on.

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