Index > Briefing
Wednesday, June 02, 2021
The Changing Role of Central Banks amidst the Pandemic

The COVID-19 pandemic has brought about a huge impact on the global economy and society, affecting our production and lifestyle in the long run. Such changes in social and economic models have led to adjustments and rethinking of some conventional economic theories and experiences. In such a new world, it would be necessary for everyone to adapt to the changes of economic activities in the post-pandemic period with new theories and institutional tools, and discover new laws of economic operation. The changes in the new policy regime are shaping the economics of the pandemic. Increasingly, governments are getting involved in economic activities on a large scale in a new way in attempt to save the economic activities hit by the pandemic and make up for the losses suffered by households and enterprises. This new situation has been accompanied by a significant change in the roles and policy tools of central banks along with unprecedented fiscal stimulus packages.

The modern monetary theory (MMT) that was used to deal with the 2008 financial crisis has also been widely applied to deal with the current economic and financial crisis brought about by the pandemic. Finance ministries of countries in the world have played a more important role this time. Not only did the U.S. government massively expand fiscal spending to make up for the losses suffered by enterprises and households, major European countries have also provided massive subsidies to enterprises and households to cope with the crisis, regardless of the constraints of fiscal deficits. Central banks, on the other hand, are clearly in a subordinated position, and the independence of central banks, which used to be considered extremely important, has been greatly challenged. On the one hand, central banks have had to continue to execute quantitative easing (QE) and monetize fiscal deficits. On the other hand, central banks have also enhanced the flexibility of monetary policy by revising their policy targets, focusing more on the economic recovery rather than on the

At the same time, the role of central banks as lender of last resort (LLR) has been changing since 2008 as the global financial system deepens and capital markets continue to boom. The Covid-19 crisis has forced central banks to assume the role of market-maker of last resort (MMLR). This will have a profound impact on both capital markets and the financial system. Major central banks, such as the Federal Reserve, the Bank of Japan, and the European Central Bank, increased the scope and scale of financial asset purchases during the pandemic. These measures not only provided liquidity support to financial institutions, but also a guarantee for the minimum price of financial assets, thereby preventing a chain reaction in the financial and economic sectors by avoiding a collapse in market prices.

Research conducted by the People's Bank of China (PBoC) has also noted this change. Sun Tianqi, director-general of the Financial Stability Bureau of the PBoC, has pointed out that the central banks of several major developed economies such as the Federal Reserve assumed the function of MMLR in their bailout practices during the subprime mortgage crisis in 2007. This happened too during the COVID-19 pandemic in 2020, in order to bail out a broader range of financial markets and financial products. According to the research of Sun Tianqi et al., the continuous increase in the share of direct financing in the financial market, the increasing variety of financial instruments, and the increasing number of alternative channels of conventional credit all show signs of the changing role of central banks. Whether this new model of the bailout will bring moral hazard and distortion to the market remains to be observed in the long run.

In terms of the bailout, the conventional role of LLR is difficult to be exerted effectively with the increasing number of non-bank financial institutions and longer financial transmission chains, given the increasingly developed capital markets and the growing share of direct financing. Financial markets assume the role of financial resource allocation, and a decline in asset prices often involves a large number of investment institutions and affects a wider range of enterprises. As a result, central banks have had to change their role to bailout enterprises and stabilize economies by purchasing financial assets to stabilize asset prices and thus financial markets. However, this has also led to a further shift in the role of central banks, leading to rising levels of corporate leverage and a sustained increase in the price and size of financial assets. This will be the root cause of the increasing financialization of the macroeconomy in the post-pandemic period.

The difference between the LLR and the MMLR lies in that LLR focuses on bailing out financial institutions; MMLR, on the other hand, stabilizes the financial system by stabilizing the price of financial assets. Under the conventional financial and economic theories, there are many controversies about the changing role of central banks. It is thought that this can lead to moral hazard, distorting risk pricing and market demand. In addition, it has also been suggested that such situation can lead to the normalization of unconventional monetary policy, which in turn causes monetary policy being hijacked by the financial market. The consequence will be an expanding credit in the economy, pushing the economic system to "decouple from the real economy", thus putting the monetary policy in a difficult position. Under the role of MMLR, the central bank's conventional interest rate policy will lose its function, the role of policy interest rate in anchoring prices in the growing financial market will become weaker, and currency is even more likely to evolve into a public good. This will lead to a new situation of zero interest rate in the monetary and financial environment.

According to the conventional theoretical framework, these short-term policy mechanisms are expected to bring about great side effects, such as inflation problems, social wealth distribution problems, and so on. However, in the context of a dramatically changed economic situation, these policy consequences may be different and, at least in the short term, feasible and effective in responding to the pandemic crisis. On the one hand, the development of the financial system and the new technology have brought about a greater space for the virtual economy, which has changed the conventional demand. On the other hand, globalization and the information market system make the market adjustment to be faster.

According to ANBOUND researchers, both the massive QE policy and the policy of fiscal monetization advocated by MMT imply that the two main policy bodies, i.e., central bank and department of finance, are converging in the post-pandemic period, and the role of the central bank, as an independent implementer of monetary policy, has been taken over by the systemic macro policy system of the government. The government is playing an increasingly important role in economic activities, not only as a market regulator, but also as a dominant player in the market. This will undoubtedly deal a blow to the conventional free-market system, and bring about new changes in economic and social activities.

Final analysis conclusion:

The economics of the post-pandemic period that rises in response to the impact of the pandemic has changed the conventional role of central banks. While the long-term impact remains to be seen, it has posed a challenge to the conventional economic policy system.

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