Economics in the Time of COVID-19
hit, because of trade policy uncertainty. A tightening of financial conditions has much
less of an effect on economic activity so long as the level of financial conditions is in
accommodative territory.
The financial conditions threshold VAR has implications for monetary policy. If
financial conditions remain accommodative through the market turbulence, in part
because conditions were quite accommodative before the virus hit, then monetary
policy easing has relatively little traction to support economic performance through the
standard channels of consumer wealth or business cost of capital, because these are not
the constraints on consumer or business behaviour. Rather, uncertainty and sentiment
are the constraints. But if the hit to confidence is large enough and markets correct
sufficiently, financial conditions could enter into tight territory, which opens the door
for central bank policy.
- The interlinkage between economic conditions, financial conditions and
uncertainty/sentiment increases the challenges facing policy authorities.
For central banks, so long as the level of financial conditions remains accommodative,
central bank easing will not be an effective response to support the real economy. If the
rise in uncertainty, the hit to sentiment, as well as the data are sufficiently great so as to
yield an overall tight level of financial conditions, a monetary policy response would
be warranted to avoid a market overshoot beyond that consistent with the expected path
of the real economy. But, this is a challenging confidence game. Fiscal authorities also
face challenges. Although many do have room to manoeuvre, particularly those that
have enjoyed very low sovereign rates for the last decade, the types of fiscal response
to the outbreak (crisis healthcare, crisis support for business and consumers) are not
structural supply-side choices, which heretofore had been our recommended use of
fiscal space.
References
Cecchetti, S G, M Feroli, A K Kashyap, C L Mann and K L Schoenholtz (2020),
“Monetary Policy in the Next Recession?”, US Monetary Policy Forum 2020.
About the author
Catherine L. Mann is the Global Chief Economist at Citibank, where she is responsible
for thought leadership, research guidance of a global team of economists, and cross-
fertilization of research across macroeconomics, fixed- income, and equities. Prior to
this position, she was Chief Economist at the OECD, where she also was Director of the