10 April 2020

Vox: Monetisation: Do not panic

Olivier Blanchard, Jean Pisani-Ferry The extraordinary operations that are under way in most countries in response to the COVID-19 shock have raised fears that large-scale monetisation will result in a major inflation episode.

In response to the sanitary crisis, extraordinary operations are under way in most countries (Baldwin and Weder di Mauro 2020). Exceptionally large, often open-ended fiscal support programmes have been launched and they are being coupled with exceptionally large purchases of government bonds. In the UK, the Treasury and the Bank of England have just announced the temporary reactivation of a scheme that makes it possible for the central bank to finance public spending directly.

These developments have raised fears that large-scale monetisation will result in a major inflation episode. Yet, other commentators would like the central banks to do even more and embark on some form of ‘helicopter money’ (e.g. Galí 2020). 

This column is an attempt to clarify what we see as a confused discussion.  

Let us start with the easy part. Governments everywhere are channelling funds to companies and households to protect them from the fallout of the economic contraction. In a way, they are practicing what the proponents of helicopter money asked for – but in a much more targeted way than anything central banks could ever do. As a result (and because of the drop in government revenues), fiscal deficits are exploding. At the same time, central banks have initiated new, large-scale government bond purchase programmes. The question is no longer whether monetary institutions will embark on direct transfers, as supporters of helicopter money had asked for, but whether we are seeing in effect the equivalent – namely, large-scale monetisation of the deficits – and if so, what the future implications will be.    

What is monetisation?

Monetisation is an ambiguous concept.  Evidently, not all central bank purchases of government bonds qualify as such.  In the US, the Fed buys and sells government bonds all the time so as to achieve an interest rate consistent with its mandate of low inflation and full employment. In the euro area, the traditional modus operandi of the ECB was to repo government bonds, which equally affects the market equilibrium. The influence of centrals banks on the government bond market has been magnified since they have embarked on quantitative easing (QE). Their aim has been to broaden the set of interest rates that they are able to influence and thereby to flatten the yield curve, even when the policy rate is at, or below, zero.  Sustained, large-scale government bonds purchases have become part of the toolbox of central banks, irrespective of the fiscal policy stance.  

So, worries cannot be about the principle of central banks buying government bonds. They must be about them buying too many of them and for the wrong reasons – what one might call excess monetisation, motivated by public finance sustainability objectives rather than price or macroeconomic stability objectives.  

What would then be the consequences? To think about the potential effects of excess monetisation, it is useful to start with a simple proposition.  

To a first approximation, when interest rates are equal to zero, the purchase of bonds by the central bank in exchange for money – that is, the degree to which public debt is monetised – does not affect public debt dynamics.  The reason is simple: it just replaces a zero interest rate asset, called debt, by another one, called money. This is true whether none of the deficit, some of the deficit, or all the deficit is financed by issuing money.

If this were the end of the argument, it would be hard to see why central banks would ever embark on such monetisation. And, indeed, the proposition must be refined in at least three ways.    

First, the eventual impact of central bank purchases of government bonds depends on what will happen in the future when economic activity and inflation are such that the central bank will want to increase interest rates. Monetisation today may affect expectations of what will happen then. 

Second, when there is one central bank, many national treasuries, and different rates for different sovereign bonds (as in the case of the euro area), monetisation does affect the distribution of risk across countries. 

Third, when markets becoming dysfunctional, or become potentially subject to multiple equilibria, monetisation – or even the threat of monetisation – can improve market functioning and avoid the convergence of expectations on ‘bad equilibria’.  .....

Conclusions

So far, there is no evidence that central banks have given up, or are preparing to give up, on their price stability mandate. It may eventually happen, if the fiscal cost of the crisis proves to be unbearable, but the size of the current public bond purchases should not be regarded as indicative of future excess monetisation. 

In the specific case of the euro area, the ECB’s bond-buying purchase programme can evidently serve as a channel for mutualising the cost of the crisis. This is in part by default: we see good reasons why part of the burden of fighting the pandemic should be mutualised among EU members, but it would be more appropriate to do so in a more transparent way through explicit budgetary and financial channels. 

So far, no agreement has been reached on such schemes, and this is unfortunate. But this is no reason to interpret ECB actions as mainly distributional. The PEPP is not a hidden budgetary mechanism. At a time when investors are prone to nervousness, its main purpose is to prevent the convergence of expectations on a bad, self-fulfilling crisis equilibrium. Such action serves the interest of all the members of the eurozone. 

In short, there are obviously some reasons to worry, but we see no reason to panic. The central banks are doing the right thing. Their actions are sustainable. And they have not tied their hands to the inflation mast. 

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