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Limits of monetary policy

Lower interest rates can mitigate a little of the economic damage done by the coronavirus, but they cannot do very much
March 12, 2020

What can monetary policy do? The question matters because the Bank of England has followed the US Federal Reserve and cut Bank rate as a precaution against the economic impact of the coronavirus. There are, however, serious doubts as to whether this will work.

What lower interest rates can do is to support demand, simply because – at the margin – they encourage consumers and companies to spend more. In this way, it can mitigate the adverse impact of weaker external demand – Chinese car purchases fell by 80 per cent in the year to February – and of the loss of wealth and higher cost of capital caused by lower share prices.

There are, however, serious limits to its effectiveness.

One is simply magnitude and timing. Bank of England economists estimate that the half-point cut in rates will add0.3 per cent to GDP – after several months. That’s nowhere near to offsetting the worst-case impact of the coronavirus. 

Secondly, lower interest rates only support demand generally. They cannot target those industries worst affected by the virus, such as pubs and restaurants and the tourism businesses that would suffer if people stay at home.

Thirdly, the virus doesn’t just reduce demand. It also acts as a supply shock. If people stay off work to self-isolate, or because schools close, then output would fall. The same will happen to companies that face disrupted supply chains if imports from China fall. This would tend to create shortages and inflation. This isn’t an obstacle to lower rates, as the Bank should look through temporary price rises. But it is something that monetary policy cannot address.

Fourthly, there is a big danger that otherwise solvent companies might be forced out of business by a temporary lack of cash flow. In principle, of course, in a well-functioning financial system banks should lend to such companies to see them through temporary troubles. Whether we have a well-functioning financial system is, however, more questionable than it should be. As we discovered during the financial crisis, a low official price of credit does not always translate into a ready availability of credit for those who need it. The Bank’s Term Funding Scheme is intended to incentivise lending to SMEs. From the point of view of addressing the impact of Covid-19, this scheme might be more important than the rate cut.

What we need, therefore, are measures that are better targeted than mere interest rate cuts. One such measure would be for the Bank to ensure that banks lend to healthy, but temporarily troubled, banks. This used to be done by moral suasion, but today bribes might work better. Other measures should include sick pay for self-employed and gig workers to encourage them to self-isolate if they are at risk of the virus rather than stay at work and risk infecting others.

Perhaps, though, there is a wider message here – that we need to rethink the role of economic policy. There used to be a consensus between the Thatcher government and New Labour that economic policy should merely set a stable framework and that activism should be largely confined to monetary policy. This consensus should have been destroyed by the financial crisis and subsequent decade-long stagnation in productivity. The need for specific measures to contain the economic damage of the coronavirus should reinforce the message that sometimes, macroeconomic policy is not enough.