Thinking Beyond the Pandemic: Monetary Policy Challenges in the Medium- to Long-Term

Thinking Beyond the Pandemic:
Monetary Policy Challenges
in the Medium- to Long-Term
Marek Dabrowski
No. 504 (2021)
CASE Reports
This paper was prepared for the European Parliament’s Committee on Economic
and MonetaryAffairs (ECON) as an input to the Monetary Dialogue of March 2021
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paper is available on the European Parliament’s webpage, as part of a series of
papers on "Recalibrated Monetary Policy Instruments to Address the Economic
Fallout from COVID-19":
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Copyright remains with the European Parliament at all times.

“CASE Reports” is a continuation of “CASE Network Studies & Analyses” series.
Keywords:
COVID-19 pandemic, monetary policy, forced saving, monetary overhang, quantitative
easing, inflation, fiscal dominance
JEL Codes:
E31, E41, E51, E52, E58, E62, E63, F62, H62, H63
© CASE – Center for Social and Economic Research, Warsaw, 2021
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Thinking Beyond the
Pandemic: Monetary
Policy Challenges in
the Medium- to
Long-Term
Policy Department for Economic, Scientific and Quality of Life Policies
Directorate-General for Internal Policies
Author: Marek DABROWSKI
PE 658.221 - March 2021
EN
STUDY
Requested by the ECON committee
Monetary Dialogue Papers, March 2021

Abstract
The economic characteristics of the COVID-19 crisis differ from
those of previous crises. It is a combination of demand- and
supply-side constraints which led to the formation of a monetary
overhang that will be unfrozen once the pandemic ends.
Monetary policy must take this effect into consideration, along
with other pro-inflationary factors, in the post-pandemic era. It
must also think in advance about how to avoid a policy trap
coming from fiscal dominance.
This paper was provided by the Policy Department for Economic,
Scientific and Quality of Life Policies at the request of the
committee on Economic and Monetary Affairs (ECON) ahead of
the Monetary Dialogue with the ECB President on 18 March 2021.
Thinking Beyond the
Pandemic: Monetary
Policy Challenges in
the Medium- to Long-
Term
Monetary Dialogue Papers
March 2021

This document was requested by the European Parliament's committee on Economic and Monetary
Affairs (ECON).
AUTHOR
Marek DABROWSKI, CASE – Center for Social and Economic Research
ADMINISTRATOR RESPONSIBLE
Drazen RAKIC
EDITORIAL ASSISTANT
Janetta CUJKOVA
LINGUISTIC VERSIONS
Original: EN
ABOUT THE EDITOR
Policy departments provide in-house and external expertise to support European Parliament
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Email: Poldep-Economy-Science@ep.europa.eu
Manuscript completed: February 2021
Date of publication: March 2021
© European Union, 2021
This document was prepared as part of a series on “Recalibrated Monetary Policy Instruments to
Address the Economic Fallout from COVID-19”, available on the internet at:
https://www.europarl.europa.eu/committees/en/econ/econ-policies/monetary-dialogue
DISCLAIMER AND COPYRIGHT
The opinions expressed in this document are the sole responsibility of the authors and do not
necessarily represent the official position of the European Parliament.
Reproduction and translation for non-commercial purposes are authorised, provided the source is
acknowledged and the European Parliament is given prior notice and sent a copy.
For citation purposes, the publication should be referenced as: Dabrowski, M., Thinking Beyond the
Pandemic: Monetary Policy Challenges in the Medium- to Long-Term, Publication for the committee on
Economic and Monetary Affairs, Policy Department for Economic, Scientific and Quality of Life Policies,
European Parliament, Luxembourg, 2021.

Thinking Beyond the Pandemic: Monetary Policy Challenges in the Medium- to Long-Term
3 PE 658.221
CONTENTS
LIST OF FIGURES 4
LIST OF TABLES 4
LIST OF ABBREVIATIONS 5
EXECUTIVE SUMMARY 7
1. INTRODUCTION 8
2. THE ECONOMIC CHARACTERISTICS OF THE COVID-19 PANDEMIC 10
2.1. The dynamics of the COVID-19 pandemic and its prospects 10
2.2. The limited state of knowledge on the COVID-19 pandemic, its impact on pandemic
management, and economic activity 12
2.3. Characteristics of the COVID-19 economic crisis 13
2.4. Crisis implications for monetary and fiscal policies 14
3. MONETARY POLICY DECISIONS 2019-2021 AND THEIR SHORT-TERM IMPACT 17
3.1. Monetary policy decisions of the ECB 17
3.2. Monetary policy decisions of the Fed and BoJ 19
3.3. Impact of monetary policy decisions on CB balance sheets and money supply 20
3.4. QE and an impaired monetary transmission mechanism 23
3.5. Monetary conditions outside major currency areas 24
3.6. CPI inflation and changes in asset prices 25
3.7. The nexus between monetary and fiscal policies 30
4. CHALLENGES FACED BY CENTRAL BANKS AFTER THE PANDEMIC 31
4.1. The potential return of inflationary pressures 31
4.2. Increasing fiscal dominance 33
4.3. Risks to financial stability 34
5. CONCLUSION 35
REFERENCES 37

IPOL | Policy Department for Economic, Scientific and Quality of Life Policies
PE 658.221 4
LIST OF FIGURES
Figure 1: COVID-19 pandemic: daily new cases (left panel) and daily deaths (right panel) in the
world, in thousands, 2020-2021 10
Figure 2: Cumulative COVID-19 vaccination doses administered per 100 people (logarithmic
scale), 01.01.2021 – 11.02.2021 11
Figure 3: Gross household saving rate, in % of GDP, 2017-2020 14
Figure 4: ECB net asset purchases in EUR billion, March 2015 – January 2021 18
Figure 5: PEPP: total bimonthly net asset purchases, in EUR million, March 2020 – January 2021 18
Figure 6: Securities held outright by the Fed, in USD million, January 2019 – February 2021 20
Figure 7: CB total assets, January 2019 – December 2020 21
Figure 8: Major currency areas: CB balance sheets as % of nominal GDP 21
Figure 9: Major currency areas: broad money, March 2019 – December 2020 (quarterly data) 22
Figure 10: Composite bank lending rates for NFCs and households in the euro area, annual in %,
2014-2020 22
Figure 11: Money multiplier (broad money to monetary base) in major currency areas 2019-2020 23
Figure 12: CB liabilities to other depository corporations, major currency areas, 2019-2020 24
Figure 13: 12-month inflation in major currency areas, in %, 2019-2021 25
Figure 14: Price of crude oil WTI, in USD per 1 barrel, 2020-2021 26
Figure 15: Measures of underlying inflation in the euro area, 12-month rate in %, 2019-2020 27
Figure 16: US Dow Jones Industrial Average (left-hand scale, blue line) and Euro Stoxx 50 Market
Index (right-hand scale, black line), 18 February 2020-18 February 2021 28
Figure 17: US (left-hand scale, blue line) and euro area (right-hand scale, black dotted line)
Nominal Home Prices Indexes, 18 February 2020-18 February 2021 28
Figure 18: Price of gold in USD for 1 troy ounce, 2016-2021 29
Figure 19: Price of Bitcoin in USD for 1 unit, 2016-2021 29
LIST OF TABLES
Table 1: Euro area, Japan, and the United States: general government gross debt, % of GDP,
2007-2019 15

5 PE 658.221
LIST OF ABBREVIATIONS
ABSPP Asset-backed securities purchase programme
AEs Advanced economies
APP Asset purchase programme
BoJ Bank of Japan
CARES Coronavirus Aid, Relief, and Economic Security (Act)
CB Central bank
CBPP3 Third covered bond purchase programme,
CDSs Collateral default swaps
COVID-19 Coronavirus Disaease 2019
CPI Consumer Price Index
CSPP Corporate sector purchase programme
DFR Deposit facility rate
EA Euro area
ECB European Central Bank
EM Emerging market
ETFs Exchange-traded funds (in Japan)
EU European Union
EUR Euro
Fed Federal Reserve Board (of the United States)
FFR Federal Fund Rate
FOMC Federal Open Market Committee
GDP Gross domestic product
GFC Global financial crisis

PE 658.221 6
HICP Harmonised index of consumer prices
IMF International Monetary Fund
JPY Japanese yen
J-REITS Japanese real estate investment trusts
MLFR Marginal lending facility rate
MM Money multiplier
MRO Main refinancing operations (rate)
NFCs Non-financial corporations
PSPP Public Sector Purchase Programme, ,
PSBR Public sector borrowing requirement
PELTRO Pandemic Emergency Longer-Term Refinancing Operations
PEPP Pandemic Emergency Purchase Programme
QE Quantitative easing
TLTRO Targeted Longer-Term Refinancing Operations
UPMs Unconventional policy measures
USD United States dollar
VAT Value Added Tax

7 PE 658.221
EXECUTIVE SUMMARY
• In February 2021, one year after the outbreak of the COVID-19 pandemic, it is hard to see its quick
end, despite the development of vaccines and the beginning of a mass vaccination programme.
Fighting the pandemic may take longer and cost more (in terms of number of deaths; GDP; and
fiscal, job, and personal income losses, among others) than originally expected. Worse, the
knowledge on the ways and speed of the spread of coronavirus remains limited, which forces
governments to rely on trial and error in adopting containment measures. Obviously, this
increases economic uncertainty.
• The economic characteristics of the COVID-19 crisis differ from the global financial crisis of
2007-2009 and other past financial crises and business cycle downturns. It is a combination of
demand- and supply-side shocks that led to the formation of forced saving and monetary
overhang. Despite this difference, governments and central banks reacted with a massive fiscal
and monetary relaxation (as they did in 2007-2009), which was costly and not sufficiently targeted.
• The intensification of asset purchasing programmes was the main policy tool that could be
used by central banks to further ease their monetary policies. However, they only partly
achieved their declared goal, that is, increasing the liquidity of economic agents. Part of the
additional monetary base returned to central banks in the form of voluntary deposits from
commercial banks, repeating the experience of quantitative easing in the 2010s. This confirms that
asset purchasing programmes are an imperfect monetary policy tool that weakens financial
intermediation and impairs the monetary policy transmission mechanism.
• Quantitative easing also increases the stock of government securities in central bank books
(de facto debt monetisation), leading to fiscal dominance and narrowing the room for
manoeuvre of monetary policy when the latter needs to be tightened. Eventually, this may
compromise central bank independence and make them tolerant of higher inflation.
• Monetary tightening may become necessary once the pandemic ends and the accumulated
monetary overhang is unfrozen. Higher inflationary pressures can also be generated by other
factors such as overshooting stimulus packages, supply bottlenecks, the expiring deflationary
impact of tighter financial regulations, demographic changes, deglobalisation, and the
deterioration of fiscal balances.
• Governments and central banks should think ahead about how to avoid a policy trap caused
by rapidly growing public debt and its de facto monetary financing, especially in the context
of the potential return of inflationary pressures. They should carefully balance the short-term
needs of fighting the pandemic and its adverse socio-economic consequences and the long-term
constraints and challenges.

PE 658.221 8
1. INTRODUCTION
In the first quarter of 2020, the COVID-19 pandemic hit the entire world economy in an unexpected
way. A year later (February 2021), it is hard to see its quick end, despite having developed vaccines and
begun a mass vaccination programme in several advanced economies (AEs).
Most governments responded to the outbreak of the pandemic with strict lockdown measures to
protect peoples’ lives and to limit the contagion effect. Clearly, the pandemic itself and the
accompanying lockdown measures heavily damaged economic activity. Governments had to offer
financial relief both to suffering businesses and the population at large. Together with the costs of
fighting pandemics, foregone revenue (the effect of the pandemic-related recession) and attempts to
boost aggregate demand, it has led to a huge expansion of both fiscal deficit and public debt.
Major central banks (CBs), on their own, responded to the crisis with a new round of monetary
relaxation. In fact, it had already started in 2019, well before the pandemic. The pandemic only
accelerated and magnified an easing response. Because CB interest rates remained either low (the
Federal Reserve Board of the United States, henceforth the Fed), zero, or even negative (the European
Central Bank [ECB] and the Bank of Japan [BoJ]), monetary relaxation has had to rely largely on asset
purchasing programmes (APPs), popularly called quantitative easing (QE). Its declared intention has
been to provide additional liquidity to pandemic-stressed businesses and consumers and meet the
declared annual inflation target of 2 or close to 2%, depending on the currency area. A less declared or
undeclared policy goal, especially in the case of the ECB, has been to help governments to finance their
fresh deficits and rollover the existing stocks of public debt, in some cases a challenging task long
before the pandemic (think about Japan and some euro area countries).
What could be seen as a relatively short-term distress in the early 2020s now looks like a longer crisis
episode. While the strict lockdown measures were relaxed in most countries of the Northern
Hemisphere at the end of the second and beginning of the third quarter of 2020, the next waves of the
pandemic created the necessity to reintroduce them, although in a more selective and targeted way.
Due to difficulties in predicting the length of the pandemic and its probable end date, economic
decisions on both the macro and micro levels are burdened with a high degree of uncertainty.
Against this background, CBs continue their expansionary monetary policies by extending the period
of unconventional policy measures (UPMs) and expanding the size of APPs. For example, on 10
December 2020, the ECB Governing Council approved a package of decisions extending their anti-crisis
measures taken in 2020 for most of 2021 (ECB, 2020). The huge increase of CB balance sheets is one of
major results of these expansionary policies. It may lead to an inflationary pressure in the post-
pandemic period (once the lockdown measures end) even if the current consumer price inflation (CPI)
remains very low, as in the case of the euro area. There are also other risks associated with the
continuation of extra-loose monetary policies, such as building asset bubbles, the engagement of
financial institutions in less prudent transactions, distorting a financial sector business model,
increasing income and wealth inequalities, and others.
In the current circumstances, CBs do not seem to put sufficient attention to these side effects and
remain rather unprepared to respond to the risk of inflationary pressure quickly enough. Furthermore,
their de facto increasing engagement in public debt financing (even if carried out via secondary market
purchases with only monetary policy considerations in mind) can make them hostages of quickly
expanding fiscal imbalances. In such circumstances, shrinking their balance sheets can be politically
difficult.

9 PE 658.221
The purpose of this briefing paper is twofold: (i) to assess the anti-crisis monetary policymeasures taken
by the ECB in 2019-2020, including their last package of December 2020, and (ii) to look beyond an
immediate COVID-19-related policy horizon by analysing monetary policy challenges in the medium-
to long-term.
Our working hypothesis is that the anti-crisis measures of the ECB and other major CBs are only partly
effective in achieving the declared goals. On the other hand, they may produce various unintended
negative side effects – in particular, the increasing monetary policy dependence on fiscal imbalances
and rapidly growing public debt. This may compromise both the independence of CBs as well as their
ability to effectively resist post-pandemic inflationary pressures.
The structure of the paper is subordinated to its declared analytical purpose. Chapter 2 deals with the
economic characteristics of the COVID-19 pandemic and its impact on the effectiveness of the
monetary policy response measures undertaken. In Chapter 3, we analyse the monetary policy
decisions of the ECB (and other major CBs for comparison) and their effectiveness in achieving the
declared policy goals in the short term. Chapter 4 is devoted to an analysis of the policy challenges
which may be faced by the ECB and other major CBs once the pandemic emergency comes to its end.
Chapter 5 contains a summary and the conclusions of our analysis.
In our analysis, we use the data sources of the International Monetary Fund (IMF), Eurostat, the ECB, the
Fed, Worldometer, Our World in Data, and those collected by other researchers.

PE 658.221 10
2. THE ECONOMIC CHARACTERISTICS OF THE COVID-19
PANDEMIC
In this chapter, we analyse the dynamics of the COVID-19 pandemic and its prospects (Section 2.1); the
state of knowledge on the pandemic, its management, and its economic repercussions (Section 2.2);
the nature of the economic crisis caused by the pandemic and how it differs from previous crises, in
particular, the global financial crisis (GFC) of 2007-2009 (Section 2.3); and its implications for monetary
and fiscal policies (Section 2.4).
2.1. The dynamics of the COVID-19 pandemic and its prospects
To understand the economic impact of the pandemic in the short and medium- to long-term, we must
first analyse its actual and future dynamics.
The first cases of the new COVID-19 infection were registered in the Chinese city of Wuhan in December
2019. In late February and early March 2020, it spread to Europe and the United States. A year later, at
the time of writing this paper (February 2021), the figures for daily new cases and deaths worldwide
(Figure 1) remain high. The figures were increasing rapidly until January 2021. As of 11 February 2021,
the total number of identified COVID-19 cases exceeded 108 million and total number of COVID-19-
related deaths – 2.3 million1
.
Figure 1: COVID-19 pandemic: daily new cases (left panel) and daily deaths (right panel)
in the world, in thousands, 2020-2021
Source: Worldometers, https://www.worldometers.info/coronavirus/.
1 See Worldometers, Coronavirus cases, https://www.worldometers.info/coronavirus/.

11 PE 658.221
Predicting the pandemic’s dynamic towards the end of 2021 is a risky and highly speculative task,
especially given the new mutations of COVID-19 (the so-called British, South African, Brazilian, and
Californian ones – see Lancet COVID-19 Commission, 2021), which were identified at the end of 2020
and in early 2021. In such a situation, one cannot rule out new waves of high-intensity infections in
2021 and perhaps beyond.
Throughout 2020, the availability of a vaccine was seen as the potential turning point in fighting
coronavirus. When several vaccines became available at the end 2020, it turned out that their
production and distribution, as well as the vaccination process itself, would take a few years to cover
the entire world population. According to the EIU (2021) forecast, only the EU, the United States, and a
few smaller countries (Israel, United Arab Emirates, Bahrain, Singapore, Hong Kong, and Taiwan) have
the chance to complete mass vaccination towards the end of 2021. In other regions of the world,
vaccination will take more time, until 2023 and beyond (most of Africa). In such a situation, thinking
about achieving herd immunity against COVID-19 is unrealistic (Dadush, 2021; Krueger, 2021),
especially when the coronavirus is mutating.
The available statistics confirm that the vaccination campaign is rolling out slowly, except from a few
small countries (Israel, United Arab Emirates, and Bahrain) and the United Kingdom (which outperforms
both the United States and the EU) – see Figure 2.
Figure 2: Cumulative COVID-19 vaccination doses administered per 100 people
(logarithmic scale), 01.01.2021 – 11.02.2021
Note: Counted as the number of single doses, which may not be equal to the vaccinated individuals.
Source: Our World in Data, Coronavirus vaccinations, https://ourworldindata.org/covid-vaccinations.
The above overview suggests that the pandemic may not end quickly, and the world economy may
have to operate in extraordinary circumstances for a longer period of time.

PE 658.221 12
2.2. The limited state of knowledge on the COVID-19 pandemic, its
impact on pandemic management, and economic activity
Despite more than a year of experience in fighting the pandemic, the state of knowledge on its actual
size, geographical spread, mechanisms of transmission, and effective containment measures remains
limited. In this section, we concentrate on those aspects of anti-pandemic management which have an
explicit economic impact, leaving aside purely medical and public health problems.
The uncertainty starts with the actual number of infections and even the number of COVID-19-related
fatalities. The reason for this is related not only to the imperfections of reporting systems in individual
countries but also to difficulties in accurately diagnosing cases without a broad-based testing system,
which is present in only a few countries. There is also a large number of asymptomatic cases, especially
in younger cohorts of the population, which are difficult to identify even with the help of broad-based
testing systems. Therefore, one can speculate that the actual number of infections is a few times larger
than what is officially recorded.
An even more limited knowledge concerns the exact channels of disease contagion. While it was clear
from the very beginning that keeping physical distance between people, limiting direct person-to-
person contact, and using face masks can slow down the proliferation of the pandemic, these actions
had to be translated into concrete protection measures aimed at prohibiting or limiting various types
of activities. In choosing concrete containment measures, knowledge on the factors facilitating the
spread of coronavirus (for example, indoor versus outdoor activities, weather conditions, the
seasonality of infections, and the role of schools, among others) plays a decisive role. However, such
knowledge is either lacking or very limited and uncertain. Furthermore, there are difficulties explaining
cross-country differences in the number of infections and deaths, which could help understand the
factors responsible for the contagion and evaluate the effectiveness of various anti-pandemic
strategies.
The limited state of knowledge determines the policy responses to the crisis, which are based, in most
cases, on trial and error. This approach is reflected in the stop-go policy carried out in most countries.
The policy response began with far-reaching and rather untargeted containment measures in most of
Europe and the United States2
at the end of the first quarter and beginning of the second quarter of
2020 with the hope that they would stop the spread of coronavirus and stop the pandemic in a
relatively short period of time. When the huge economic costs of mass lockdowns became evident
(GDP decline was positively correlated with stringency of containment measures – see IMF, 2020;
Marcus et al., 2021) and the first wave of pandemic seemed to be over in several AEs (but not globally
as seen in Figure 1), governments began relaxing the lockdown measures at the end of the second and
in the third quarter of 2020. Economic activity started to recover at a quite rapid pace in the third
quarter of 2020 (IMF, 2021a).
However, the return of the pandemic in the autumn of 2020 forced most governments to reintroduce
lockdown measures, although in a more targeted way than in the spring of 2020. Since then, and until
the time of writing this paper, the stringency of anti-pandemic measures fluctuates in most of AEs (see
Hale et al., 2020) depending on the most recent infection and death statistics, pressure from sectoral
lobbies, and the political controversies around anti-pandemic policies. One can say it is driven by
2 In some East Asian countries (Japan, Taiwan, South Korea, Hong Kong, and Singapore) that had earlier experience with the SARSepidemic,
authorities managed to launch a system of mass testing and tracking infection chains with the use of IT technologies early on, avoiding
more severe lockdown measures (Stancati and Yoon, 2020).

13 PE 658.221
attempting to balance socio-economic considerations and the capacity of national healthcare systems
to deal with the pandemic (Dabrowski, 2020).
While in the first half of 2020 most countries enjoyed broad social and political consensus on the
necessity to take tough containment measures, support began to wane at the end of 2020 and in early
2021 when the social and economic costs of the pandemic and lockdown continued to increase and
doubts with respect to the effectiveness of concrete anti-pandemic policies and measures intensified.
It was seen, among others, in the course of the US presidential election campaign and in the series of
anti-lockdown protests held in various countries. The most recent cases (mid-February) of political
controversy on anti-pandemic measures include tension in the newly formed government of Italy
(Amante, 2021) and the failure of the Czech parliament to prolong the state of emergency to fight the
pandemic (Euronews, 2021).
The limited state of pandemic-related knowledge additionally increases the already high degree of
uncertainty in respect of the short- and medium-term economic prospects and the unpredictability of
government decisions. Uncertainty and unpredictability dampen both private consumption (beyond
basic necessities) and even more – investment.
2.3. Characteristics of the COVID-19 economic crisis
The economic characteristics of the COVID-19 crisis are very different from the GFC of 2007-2009 and
other past financial crises or business-cycle downturns. The GFC caused a disruption in financial
intermediation, which, by its nature, had a deflationary character. There were also other deflationary
factors in play such as new, more stringent financial regulations, the effects of globalisation, and others
(Dabrowski, 2019).
The current crisis is a combination of demand-side and supply-side shocks. They result not only from
depressed aggregate demand caused by the self-restrained behaviour of both consumers and
investors but also from administrative lockdown measures such as the prohibition of certain types of
activities, restrictions on the movement of people, or closed borders and the resulting disruption of
supply chains. In such circumstances, private spending decreases and private saving increases (Figure
3), but these are forced (involuntary) savings.
One can make a historical analogy to centrally-planned economies where people and enterprises could
not spend their money balances on the goods and services they wanted to buy because they were not
available on the market (as a result of administrative price controls and the administrative distribution
of goods and services) – the phenomenon of a shortage economy as described by Kornai (1980). This
led to forced saving (flow) and monetary overhang (stock), which represented a repressed inflation
(Cottarelli and Blejer, 1991).
Apart from temporarily frozen demand- and supply-side disruptions, the COVID-19 crisis, especially if
prolonged, can lead to substantial structural changes such as the expansion of e-commerce and
various e-services (including e-government ones), telework, teleconferencing, online education, and
the contraction of business travel, traditional retailing, and, therefore, demand for office and
commercial space. At the moment, it is difficult to predict which parts of the observed structural
changes have a temporary character and will disappear after the pandemic and which have an
irreversible character.

PE 658.221 14
Figure 3: Gross household saving rate, in % of GDP, 2017-2020
Source: Marcus et al., 2021.
The right diagnosis of the ongoing structural changes is important not only for structural and
institutional policies – for example, the respective adaptation of labour market regulations – but also
for monetary and fiscal policies. First, they should facilitate such changes rather than conserving the
existing supply side structure, which might mean support for “zombie” firms and industries. If one
assumes far-reaching structural changes, estimating the output gap may become more complicated
(i.e., due to the mismatch between the new demand structure and the old supply capacities).
2.4. Crisis implications for monetary and fiscal policies
The very nature of the GFC (see Section 2.3) required a bold monetary policy response to avoid a
deflationary spiral of the kind observed during the Great Depression of 1929-1933. And because
interest rates in major currency areas quickly hit the zero bound, CBs had to resort to UPMs, including
large-scale APPs. While expansionary monetary policies achieved their strategic goal (deflation was
avoided), the process of withdrawal from UPMs in the second half of the 2010s either went slow (the
United States) or did not start at all (the euro area and Japan). The continuous fear of deflation and
attempts to push inflation up to the declared 2% – or below but close to 2% – target were major reasons
of this failure (Dabrowski, 2019).
As a result, CBs in major currency areas met the new COVID-19-related challenges with interest rates
close to zero (the ECB and BoJ) or moderately positive (the Fed). Therefore, monetary relaxation
required resorting to UPMs, mainly APPs.
There is also a more fundamental question on which kind of monetary policy response has been
required, given the specific character of the COVID-19 crisis analysed in Section 2.3, which is quite
different from both the GFC and standard business cycle downturns. Indeed, the surprise outbreak of
10,
12,
14,
16,
18,
20,
22,
24,
26,
2017-Q4 2018-Q1 2018-Q2 2018-Q3 2018-Q4 2019-Q1 2019-Q2 2019-Q3 2019-Q4 2020-Q1 2020-Q2 2020-Q3
Euro area - 19 countries (from 2015) European Union - 27 countries (from 2020)

15 PE 658.221
the pandemic and the far-reaching lockdown measures in the first half of 2020 caused a negative
aggregate demand shock in parallel with a supply-side disruption. The increase in gross household
saving (Figure 3) confirms the correctness of this diagnosis. CBs might also fear a potential disruption
in financial intermediation as happened during the GFC, so providing additional liquidity seemed to be
the right decision. However, once lockdown measures were relaxed in the third quarter of 2020 and
then continued in a more selective way, the rationale behind the continued monetary expansion
requires a closer analytical scrutiny. And this will be done in Chapter 3 of this paper.
Given the nature of the COVID-19 crisis, the main macroeconomic policy response should come from a
fiscal policy side. Governments are confronted with the necessity to:
• finance the direct costs of fighting the pandemic (mostly related to public health measures);
• provide financial compensation to people and businesses directly affected by the economic
consequences of the administrative lockdown measures; and
• accommodate for revenue losses and additional social spending resulting from the crisis-related
recession (automatic fiscal stabilisers).
This is the minimum agenda of a fiscal response. On top of this, several governments developed various
fiscal stimulus packages aimed at boosting aggregate demand or stimulating public investment
programmes (Skidelsky, 2021). The design of these packages differs between countries (IMF, 2021b).
The basic constraint comes from the limited fiscal space in most AEs (Table 1). Their fiscal positions
substantially deteriorated during the GFC and immediately after (Dabrowski, 2012) and only a few of
them (Germany is the most prominent example) managed to use the post-GFC period to rebuild fiscal
buffers.
Against the limited fiscal space, governments should use fiscal support measures wisely and carefully.
In particular, they should assess whether they have enough fiscal space for a large-scale fiscal stimulus
aimed to boost aggregate demand, if they can expect fiscal multipliers to be above one (only in such a
situation can the stimulus be self-financing), and what will be the optimal timing of its launching
(before the end of the pandemic when demand and supply constraints remain in force or after the
termination of containment measures).
Table 1: Euro area, Japan, and the United States: general government gross debt, % of
GDP, 2007-2019
Country 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Euro area 65.9 69.6 80.2 85.8 87.7 90.7 92.6 92.8 90.9 90.0 87.6 85.7 84.0
Austria 64.7 68.4 79.6 82.4 82.2 81.7 81.0 83.8 84.4 82.6 78.4 74.0 70.3
Belgium 87.3 93.2 100.2 100.3 103.5 104.8 105.5 107.0 105.2 104.9 101.8 99.9 98.7
Cyprus 53.2 44.1 52.8 55.5 65.0 79.4 102.9 109.2 107.5 103.4 93.9 100.6 95.5
Estonia 3.8 4.5 7.2 6.6 6.1 9.8 10.2 10.4 9.8 9.1 9.1 8.3 8.4
Finland 33.9 32.6 41.5 46.9 48.3 53.6 56.2 59.8 63.6 63.2 61.3 59.6 59.0
France 64.5 68.8 83.0 85.3 87.8 90.6 93.4 94.9 95.6 98.0 98.3 98.1 98.1
Germany 64.0 65.5 73.0 82.4 79.8 81.1 78.7 75.7 72.2 69.2 65.0 61.6 59.5
Greece 103.1 109.4 126.7 146.3 180.6 159.6 177.9 180.2 177.8 181.1 179.3 184.8 180.9
Ireland 23.9 42.4 61.7 86.0 111.1 120.0 120.1 104.3 76.7 74.2 67.4 62.9 57.3
Italy 103.9 106.2 116.6 119.2 119.7 126.5 132.5 135.4 135.3 134.8 134.1 134.8 134.8
Latvia 8.1 18.0 35.8 46.8 43.3 41.9 39.4 40.9 36.7 40.2 40.3 36.5 36.8
Lithuania 15.9 14.6 28.0 36.3 37.2 39.8 38.7 40.6 42.7 39.9 39.3 34.1 37.7
Luxembourg 8.2 15.4 16.1 20.2 19.0 22.0 23.7 22.7 22.0 20.1 22.3 21.0 22.1
Malta 61.9 61.8 66.3 65.3 69.3 65.9 65.8 61.6 55.9 54.5 48.8 45.2 42.6
Netherlands 42.0 53.8 55.8 59.4 61.8 66.4 67.8 68.0 64.6 61.9 56.9 52.4 48.4
Portugal 72.7 75.6 87.8 100.2 114.4 129.0 131.4 132.9 131.2 131.5 126.1 122.0 117.7

PE 658.221 16
Country 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Slovakia 30.3 28.6 36.4 41.0 43.5 51.8 54.7 53.5 51.9 52.0 51.3 49.5 48.0
Slovenia 22.8 21.8 34.5 38.3 46.5 53.6 70.0 80.3 82.6 78.7 74.1 70.4 66.1
Spain 35.8 39.7 53.3 60.5 69.9 86.3 95.8 100.7 99.3 99.2 98.6 97.6 95.5
Japan 175.3 183.3 200.9 207.7 221.9 228.7 232.2 235.8 231.3 236.4 234.5 236.6 238.0
US 64.7 73.7 86.8 95.5 99.8 103.3 104.9 104.5 104.6 106.6 105.7 106.9 108.7
Source: IMF, World Economic Outlook database, October 2020.
Further deterioration of the fiscal situation (higher deficits and the rapid increase of public debt) also
raises the expectation that monetary policy will provide a rescue by keeping interest rates low for a
long period of time and by partial debt monetisation if necessary (Buiter, 2021). This creates the risk of
compromising CB independence and the price stability goal of monetary policy. We will return to this
question in Chapters 3 and 4.

17 PE 658.221
3. MONETARY POLICY DECISIONS 2019-2021 AND THEIR SHORT-
TERM IMPACT
Having characterised the economic impact of the pandemic (Chapter 2), we turn now to the monetary
policy decisions of the ECB and other major CBs in the period of 2019-2021 – that is, immediately before
the pandemic and after its outbreak. We also analyse their monetary and non-monetary effects in a
short-term perspective. We start with the presentation of the monetary policy decisions of the ECB
(Section 3.1), followed by an overview of the Fed and BoJ decisions (Section 3.2). The subsequent
sections are devoted to the impact of these decisions on CB balance sheets and money supply (Section
3.3), monetary transmission mechanisms (Section 3.4), monetary conditions outside major currency
areas (Section 3.5), CPI inflation and changes in asset prices (Section 3.6), and a monetary-fiscal nexus
(Section 3.7).
3.1. Monetary policy decisions of the ECB
The ECB was the last among major CBs to launch a large-scale APP (Dabrowski, 2019). It happened only
in March 2015, that is, when the Fed had already started to unwind its QE programmes. The ECB
continued them until December 2018, although at a slower pace in 2018 (Figure 4). After a 10-month
break, it returned to active net asset purchases in November 20193
. It was motivated, among others, by
problems with pushing inflation up to the declared level of below, but close to, 2% over the medium
term (Draghi, 2019). In our opinion (Dabrowski, 2019), it was a serious misconception because inflation
between 0-2% involves no major policy risk (see Frankel, 2019; Gros, 2019; Leidy and Tokarick, 1998).
After the outbreak of the COVID-19 pandemic, the ECB intensified and eased the conditions of its APPs4
and targeted longer-term refinancing operations (TLTRO III)5
. On the top of this, in March and April
2020, it launched new programmes – the pandemic emergency purchase programme (PEPP)6
and the
pandemic emergency longer-term refinancing operations (PELTRO)7
. The novelty of both programmes
as compared to the APPs and TLTRO III consisted of their size, greater flexibility (PEPP), and more
beneficial terms of lending (PELTRO).
As seen in Figure 4, the average size of total net asset purchases under the APPs throughout 2020 was
substantially lower than in 2015-2017, with the peak recorded in March 2020. Figure 5 shows that total
bimonthly net asset purchases under the PEPP represented a declining trend.
3 See ECB: asset purchase programmes https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html.
4 See ECB: Governing Council Meeting of 11-12 March 2020
https://www.ecb.europa.eu/press/accounts/2020/html/ecb.mg200409~0026941ce4.en.html.
5 See ECB press release, 12 March 2020: “ECB announces easing of conditions for targeted longer-term refinancing operations (TLTRO III)”,
https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200312_1~39db50b717.en.html.
6 See ECB: Pandemic emergency purchase programme (PEPP) https://www.ecb.europa.eu/mopo/implement/pepp/html/index.en.html.
7 See ECB press release, 20 April 2020: “ECB announces new pandemic emergency longer-term refinancing operations”
https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200430_1~477f400e39.en.html.

PE 658.221 18
Figure 4: ECB net asset purchases in EUR billion, March 2015 – January 2021
Note: PSPP – public sector purchase programme, CBPP3 – third covered bond purchase programme, CSPP – corporate sector
purchase programme, ABSPP – asset-backed securities purchase programme.
Source: ECB, Asset purchase programmes, https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html.
Figure 5: PEPP: total bimonthly net asset purchases, in EUR million, March 2020 – January
2021
Source: ECB, https://www.ecb.europa.eu/mopo/pdf/PEPP_breakdown_history.csv?4fccbac2ae5f38b8ae63b70d05d17fb0.
10579 7043 2707 342 1471
35384
-544 -2765 -7682 -7603
186603
198214
126832
140160
116339
-20000
0
20000
40000
60000
80000
100000
120000
140000
160000
180000
200000
220000
240000
Mar-May2020 Jun-Jul2020 Aug-Sep2020 Oct-Nov2020 Dec2020-Jan2021
Covered Bonds Corporate Bonds
Commercial Paper Public Sector Securities

19 PE 658.221
Since March 2016, the main refinancing operations (MRO) rate remained at zero and the marginal
lending facility rate (MLFR) at the level of 0.25%, while the deposit facility rate (DFR) was cut from -
0.40% to -0.50% in September 20198
.
On 10 December 2020, the ECB Governing Council took a series of decisions in which it:
• increased the envelope of the PEPP by EUR 500 billion to a total of EUR 1,850 billion and extended
the horizon for net purchases under this programme to at least the end of March 2022 and the
period of reinvestment of principal payments from maturing securities until at least the end of
2023;
• extended the period of more favourable terms of the TLTRO III by 12 months to June 2022; three
additional operations will be conducted between June and December 2021;
• extended to June 2022 the duration of the set of collateral easing measures adopted in April 2020;
• offered four additional PELTROs in 2021;
• declared the continuation of APP net purchases at a monthly pace of EUR 20 billion and reinvesting,
in full, the principal payments from maturing securities purchased under the APP for an extended
period of time.
3.2. Monetary policy decisions of the Fed and BoJ
The Fed and BoJ also reacted to the COVID-19 emergency with a new round of monetary policy easing.
The Fed cut the Federal Fund Rate (FFR) by 1.50 percentage points (to the range 0.00-0.25) in two steps
taken in March 2020. Before, between July and October 2019, the FFR was reduced in three steps by
0.75 percentage points.
In the second half of 2019, the Fed also returned to net purchases of securities, starting to again
increase its balance sheet (after its reduction between October 2017 and August 20199
). On 15 March
2020, after the outbreak of the pandemic, it decided to increase its holdings of Treasury securities by
at least USD 500 billion and mortgage-backed securities by at least USD 200 billion10
. A week later, it
eliminated upper limits of these operations11
. Within its regulatory and supervisory mandate, the Fed
also launched several sector-targeted lending programmes12
. All these measures led to an increase of
its asset holdings by approximately 75% in the period between March 2020 and February 2021 (Figure
6).
In March and April 2020, the BoJ adopted three kinds of easing measures (Kuroda, 2020): (i) a special
programme to support financing non-financial firms, worth JPY 110 trillion (the purchase of corporate
bonds and refinancing financial institutions which lend to non-financial firms); (ii) purchasing Japanese
government bonds without limits and the provision of USD funds based on cooperation with other
CBs; and (iii) purchases of certificates of exchange-traded funds (ETFs) and real estate investment trusts
8 See ECB: Key ECB interest rates
https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html.
9 See Federal Reserve: History of the FOMC's Policy Normalization Discussions and Communications
https://www.federalreserve.gov/monetarypolicy/policy-normalization-discussions-communications-history.htm.
10 See Federal Reserve, FOMC statement, 15 March 2020
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315a.htm.
11 See Federal Reserve, FOMC statement, 23 March 2020
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323a.htm.
12 See Federal Reserve, Coronavirus Disease 2019 (COVID-19) - Funding, Credit, Liquidity, and Loan Facilities
https://www.federalreserve.gov/funding-credit-liquidity-and-loan-facilities.htm.

PE 658.221 20
(J-REITS). In December 2020, it extended the period of all these programmes to at least September 2021
and enlarged their envelopes (Vogado, 2020).
Figure 6: Securities held outright by the Fed, in USD million, January 2019 – February 2021
Source: Federal Reserve, Total Assets of the Federal Reserve
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends_accessible.htm.
3.3. Impact of monetary policy decisions on CB balance sheets and
money supply
The new round of monetary relaxation launched in 2019 but intensified in 2020 (see Sections 3.1 and
3.2), in particular, increasing the size of net asset purchases, has led to the further expansion of CB
balance sheets both in nominal terms (Figure 7) and even more in relation to GDP (Figure 8), because
GDP was shrinking in 2020 in all three analysed economies.
The BoJ has been rapidly expanding its total assets since 2013, so the year 2020 brought about only a
modest acceleration. The ECB recorded a more visible change in the previous trend: after a period of a
relatively stable stock of total assets (2018-2019), they started to grow rapidly from March 2020 (by
42.7% between the end of February and the end of December 2020). However, itwas the Fed that made
the most dramatic U-turn. After a period of shrinking its balance sheet (2017-2019), it recorded a rapid
increase by 93.1% between the end of August 2019 and the end of December 2020, most of which
occurred during the period from March to June 2020.
0
1000000
2000000
3000000
4000000
5000000
6000000
7000000
02-Jan-19
02-Feb-19
02-Mar-19
02-Apr-19
02-May-19
02-Jun-19
02-Jul-19
02-Aug-19
02-Sep-19
02-Oct-19
02-Nov-19
02-Dec-19
02-Jan-20
02-Feb-20
02-Mar-20
02-Apr-20
02-May-20
02-Jun-20
02-Jul-20
02-Aug-20
02-Sep-20
02-Oct-20
02-Nov-20
02-Dec-20
02-Jan-21
02-Feb-21

21 PE 658.221
Figure 7: CB total assets, January 2019 – December 2020
Note: ECB in EUR million, BoJ in JPY hundred million, US Fed in USD million.
Source: IMF International Financial Statistics.
Figure 8: Major currency areas: CB balance sheets as % of nominal GDP
Source: Mosser, 2020.
The rapid growth of CB assets and the monetary base has led to an increase in broad money (Figure 9),
although at a slower pace than the former. The annual growth of broad money amounted to 11.5% in
3.500.000,00
4.000.000,00
4.500.000,00
5.000.000,00
5.500.000,00
6.000.000,00
6.500.000,00
7.000.000,00
7.500.000,00
8.000.000,00
Euro Area
Japan
United States

PE 658.221 22
the euro area (December 2019 to December 2020), 14.7% in the United States (September 2019 to
September 2020), and 6.9% in Japan (June 2019 to June 2020).
Figure 9: Major currency areas: broad money, March 2019 – December 2020 (quarterly
data)
Figure 10: Composite bank lending rates for NFCs and households in the euro area, annual
in %, 2014-2020
Note: Composite bank lending rates are calculated by aggregating short- and long-term rates using a 24-month moving
average of new business volumes. The latest observation is for November 2020. NFCs stands for non-financial corporations.
Source: ECB, 2021, Chart 13, p. 24.
12.000.000
14.000.000
16.000.000
18.000.000
20.000.000
22.000.000
24.000.000
Mar 2019 Jun 2019 Sep 2019 Dec 2019 Mar 2020 Jun 2020 Sep 2020 Dec 2020
EA Japan US

23 PE 658.221
However, the borrowing costs for the non-financial sector have improved only marginally, at least in
the euro area. Figure 10 shows that while composite commercial bank lending rates for households for
home purchases in the euro area continued to decrease in 2020, the similar rates for non-financial
corporations (NFCs), that is, businesses, even increased slightly in the second half of 2020.
Both the slower growth of broad money and the stabilisation or even increase in lending rates for
businesses suggest problems with the effective transmission of the bold monetary impulses provided
by CBs, which we will analyse in Section 3.4.
3.4. QE and an impaired monetary transmission mechanism
In our previous analysis (Dabrowski, 2019), we diagnosed the unintended negative impact of QE on the
depth of financial intermediation. When CBs increased their stock of assets, the money multiplier (MM),
defined as the quotient of broad money to the monetary base, decreased. When CBs stop net
purchases or decrease the stock of assets, the MM increased.
The negative impact of QE on the MM could be explained by the behaviour of commercial banks. When
CBs intensified asset purchases, commercial banks increased their voluntary deposits with CBs despite
negative deposit rates in the ECB and BoJ. When CBs stabilised or started to reduce their stocks of
assets, commercial banks gradually reduced their deposits with CBs.
Figure 11: Money multiplier (broad money to monetary base) in major currency areas
2019-2020
2,50
3,00
3,50
4,00
4,50
5,00
5,50
6,00
6,50
Mar 2019 Jun 2019 Sep 2019 Dec 2019 Mar 2020 Jun 2020 Sep 2020 Dec 2020
EA Japan US

PE 658.221 24
Figure 12: CB liabilities to other depository corporations, major currency areas, 2019-2020
Our hypothesis (Dabrowski, 2019) was that QE absorbed so many low-risk liquid securities from the
financial market that commercial banks had to increase their voluntary deposits in CBs to be able to
manage their liquidity according to prudential norms. The alternative but not radically different
interpretation was that commercial banks were restricted in their lending activities by the limited
demand for credit (despite low interest rates) or by the various regulatory limits imposed on them as
result of the far-reaching tightening of financial market regulations after 2008.
Figures 11 and 12 suggest that a negative impact of QE on the MM was also present during the newest
round of QE in 2019-2020, in particular, in the case of the Fed and the ECB. The additional factors that
could prevent the full absorption of the growing monetary base by commercial banks are related to
the economic characteristics of the current crisis. By this we mean the direct consequences of the
lockdown measures and the crisis-related uncertainty, which negatively affect investment decisions in
many sectors and industries and increase lending risk.
Overall, the above analysis points to an impaired transmission mechanism when monetary policy
resorts to UPM, especially QE.
3.5. Monetary conditions outside major currency areas
In late February and early March 2020, emerging market (EM) economies suffered from large-scale
capital outflows as result of the global financial market turmoil caused by the outbreak of the
pandemic. Capital outflow led to a rapid increase in EM collateral default swaps (CDSs), spreads
between EM bond yields and those in major currency areas, the depreciation of EM market currencies,
and the collapse of their stock markets (Dabrowski and Dominguez-Jimenez, 2020).
Fortunately, in most EMs, the adverse shock lasted only a few weeks, except in countries that were
macroeconomically fragile before the pandemic, like Argentina, Lebanon, or Turkey. The monetary
1.000.000
1.500.000
2.000.000
2.500.000
3.000.000
3.500.000
4.000.000
4.500.000
5.000.000
EA Japan US

25 PE 658.221
expansion in major currency areas (see Sections 3.1 and 3.2) has helped easing EM financial conditions
since April 2020 (Kalemli-Ozcan, 2020). Given the dominant role of the USD, the Fed’s monetary policy
has had the biggest positive impact on EM financial conditions and has helped in returning net capital
inflows; the ECB and BoJ also contributed to this relief, especially in their neighbourhoods.
Apart from monetary easing, both the Fed and the ECB launched currency swaps with several EM CBs.
The ECB also offered EUR repo lines to non-euro area CBs (Lane, 2020). On 10 December 2020, the ECB
Governing Council extended the repo facility for CBs and all temporary swap and repo lines with non-
euro area CBs until March 2022 (ECB, 2020).
3.6. CPI inflation and changes in asset prices
In 2019 and Q1 2020, the euro area recorded a 12-month inflation below 1.5% and Japan – below 1.0%.
Inflation in the United States was higher – between 1.5-2.5% (Figure 13). After the outbreak of the
COVID-19 pandemic, inflation decreased everywhere. In the second half of 2020, it became negative in
the euro area and Japan. In the United States, it was in the range of 1.0-1.5%.
Figure 13: 12-month inflation in major currency areas, in %, 2019-2021
Note: CPI inflation for the US and Japan, HICP inflation for the EA.
Sources: IMF International Financial Statistics (the US and Japan), ECB (the EA).
As mentioned in Section 3.1, low inflation in the euro area served as the key justification for a return to
QE in Q4 2019. After the pandemic outbreak, the weight of this argument in favour of continuous
monetary expansion has been further strengthened in all major currency areas (see Buiter, 2021;
Ranasinghe et al., 2020). However, one should be careful with drawing far-going conclusions from very
low or even negative inflation figures (see O’Brien et al. [2021] for a comprehensive analysis of supply-
and demand-side factors influencing inflation during the COVID-19 pandemic).
First, low inflation may result not only from the subdued aggregate demand or hypothetically
insufficient money supply but also from lockdown measures that radically change the composition of
-1,5
-1,0
-0,5
0,0
0,5
1,0
1,5
2,0
2,5
Japan US EA (HICP)

PE 658.221 26
the consumer basket13
and distort sectoral and industry-specific balances between demand and
supply.
Second, as analysed in Section 2.3, the subdued aggregate demand can have a temporary character,
resulting from anti-pandemic containment measures. It can rebound once the pandemic and
lockdown are over (unfreezing a monetary overhang resulting from forced saving).
Third, there were numerous supply-side shocks in 2020, the most notable of them being related to the
collapse of oil and other commodity prices in March and April 2020 (Figure 14).
Figure 14: Price of crude oil WTI, in USD per 1 barrel, 2020-2021
Source: Trading Economics, https://tradingeconomics.com/commodity/crude-oil.
Fourth, temporary cuts in the value added tax (VAT) in some euro area countries (Austria, Cyprus,
Germany, Greece, and Ireland) in the second half of 202014
also had a downward impact on recorded
inflation in this period. The most substantial reduction in VAT rates took place in Germany where the
basic VAT rate was lowered from 19 to 16% and the reduced VAT rate – from 7 to 5% for all goods and
services, for the period of 1 July to 31 December 2020 (Asquith, 2020). In other economies, VAT cuts
concerned only selected goods and services.
Figure 15 shows the effects of excluding changes in energy, food, travel-related items, clothing and
footwear prices, and VAT rates in Germany from the headline HICP indicator. Such an underlining
inflation measure remains in positive territory and is more stable than the headline HICP. However, it
also represents the declining trend in the second half of 2020.
13 Technically, changes in the composition of the consumer basket and the weights of individual items can be taken into consideration by
CPI statistics ex-post in the subsequent year.
14 See 2021 European Union VAT rates, https://www.avalara.com/vatlive/en/vat-rates/european-vat-rates.html.

27 PE 658.221
Figure 15: Measures of underlying inflation in the euro area, 12-month rate in %, 2019-
2020
Notes: HICPX – HICP excluding food and energy; HICPXX – HICP excluding energy, food, travel-related items, clothing and
footwear prices.
Source: ECB, 2021, Chart 8, p. 18.
The measure of underlying inflation can help to predict potential changes in the headline HICP in the
near future. By this we mean growing oil prices since November 2020 (Figure 14) and the expiration of
most temporary VAT rate cuts in Germany at the end of 2020. Perhaps the euro area positive headline
inflation of 0.8% in January 2021 reflects the impact of these changes and the beginning of a new trend.

PE 658.221 28
Figure 16: US Dow Jones Industrial Average (left-hand scale, blue line) and Euro Stoxx 50
Market Index (right-hand scale, black line), 18 February 2020-18 February 2021
Source: Trading Economics, https://tradingeconomics.com.
Figure 17: US (left-hand scale, blue line) and euro area (right-hand scale, black dotted line)
Nominal Home Prices Indexes, 18 February 2020-18 February 2021

29 PE 658.221
Figure 18: Price of gold in USD for 1 troy ounce, 2016-2021
Figure 19: Price of Bitcoin in USD for 1 unit, 2016-2021

PE 658.221 30
In our previous analysis (Dabrowski, 2019), we argued that changes in the CPI are not able to fully
capture the existing inflationary pressures because part of this pressure is absorbed by changes in asset
prices. Figures 16-17 present the dynamic of housing prices and the stock market (both in the euro area
and the United States), while Figures 18-19 – the dynamics of the prices of gold and the Bitcoin virtual
currency. They all demonstrate a strongly increasing trend during the pandemic, except the price of
gold, which after a rapid increase in the first half of 2020 moderated somewhat in the second half of
2020 and the beginning of 2021, and a short dip in stock prices in February and March 2020. This should
serve as a warning signal of the unrecorded inflationary potential and the risk to financial stability – the
two questions which we will address in Chapter 4.
3.7. The nexus between monetary and fiscal policies
Figure 4 shows that purchases of government bonds have dominated all APPs conducted by the ECB.
The same relates to APPs conducted by the BoJ, the Fed, and other CBs that engage in QE. As a result,
CBs in several AEs, including the three CBs analysed in this paper, accumulated large stocks of
government securities.
Such an effect of QE, even if originally unexpected and undesired, seems to be unsurprising and
unavoidable. Several rounds of large-scale QE since 2008 absorbed the bulk of commercial papers and
securities of sufficient quality and liquidity acceptable to CBs. Government bonds remain the only
available assets to continue QE, especially as their supply is growing rapidly due to large fiscal
imbalances and increasing public sector borrowing requirements (PSBRs) during the pandemic. The
higher supply of government bonds meets the higher demand for them by those CBs that want to
expand their APPs.
However, such a “symbiosis” has several negative consequences and involves serious risks to
macroeconomic and financial stability (see Chapter 4). Even if APPs are conducted exclusively for
monetary policy purposes (to increase the CB’s monetary base or flatten a yield curve) and via the
secondary market, they mean the de facto monetisation of public debt. QE increases demand for
government securities and makes public debt financing easier. In many instances, it reduces market
pressures on more prudent fiscal policies. It also decreases public debt service costs15
. This means that
the phenomenon of record-low nominal and real interest rates in AEs, which often serves as an
argument in favour of the further expansion of government borrowing (see Blanchard, 2019; Furman,
2020), is not only an effect of the excessive saving as compared to investment needs16
but can also be
seen as an indirect effect of QE.
Overall, as a result of QE, major CBs, including the ECB, became increasingly involved in the indirect
financing of public debt, which can narrow the monetary policy room for manoeuvre, make it more
dependent on fiscal imbalances, and compromise CB independence. We will further discuss this issue
in Chapter 4.
15 In the case of the PEPP, the ECB did not follow the strict country capital key on a monthly basis to help those euro area governments
whose yields were higher. However, towards the end of 2020, the ECB minimised such interventions.
16 See the hypothesis of secular stagnation as developed by Summers (2016) and Summers and Stansbury (2019).

31 PE 658.221
4. CHALLENGES FACED BY CENTRAL BANKS AFTER THE
PANDEMIC
Regardless of the length of the COVID-19 pandemic, it will leave behind a heavy social and economic
legacy, which will be uneasy to overcome. For this reason, policymakers should not limit their actions
and decisions to responding to today’s challenges, however serious and dramatic they are. They should
think ahead to the post-pandemic period and its challenges and assess the consequences of today’s
choices from a longer-term perspective. Too often, anti-crisis measures taken hastily today without due
consideration of the potential side effects can have serious repercussions for the future.
The postulate of thinking ahead of the curve also concerns monetary policymakers. For central bankers,
three problems in the post-pandemic era may be particularly challenging: (i) the potential return of
inflationary pressures, (ii) fiscal dominance, and (iii) risks to financial stability.
4.1. The potential return of inflationary pressures
Inflation in AEs was low during the entire decade of the 2010s (Dabrowski, 2019) and even lower in
2020, after the outbreak of the COVID-19 pandemic (see Section 3.6 and Figure 13). This may support
the expectation (based on an extrapolation of past trends) that the low inflationary environment will
continue for the next couple of years, regardless of monetary and fiscal policy decisions (see e.g.,
Blanchard, 2020; Demertzis, 2021). Some financial market forecasts even warn of a continuous deflation
risk in 2021 (Zangana, 2020).
Early 2021 official macroeconomic forecasts predict a moderate inflation pick up based on the
assumption of a gradual but relatively fast economic recovery. According to the IMF (2021a, footnote
8 to Table 1, p. 4), inflation in the euro area will amount to 0.9% in 2021 and 1.2% in 2022, in Japan –
0.1% in 2021 and 0.5% in 2022, and in the US – 2.1% in both 2021 and 2022. According to the European
Commission (2021, Table 1, p. 1), inflation in the euro area will amount to 1.4% in 2021 and 1.5% in
2022.
Inflationary expectations measured by surveys of professional opinions or derived from market-based
indicators (changes in bond yields and swap rates) also show only a very modest inflation revival, not
exceeding an annual rate of 2% (Demertzis, 2021; ECB, 2021, Chart 9; European Commission, 2021,
Graph 1.17, p. 19).
However, by their very nature, both macroeconomic forecasts and various measures of inflationary
expectations are based, explicitly or implicitly, on the assumption of the continuation of past trends
and economic behaviour and an unchanged policy regime (Blanchard, 2020). Therefore, they may not
be able to capture the actual inflation risks coming from the economic aspect of the COVID-19 crisis
(see Section 2.3), the consequences of anti-crisis monetary and fiscal policy responses (see Chapter 3),
and the longer-term demographic and structural challenges faced by AEs (Goodhart and Pradhan,
2020).
Even if the previous warnings on returning inflation (including the ones presented by the author of this
paper – see e.g., Dabrowski, 2019) have not materialised yet, it does not mean that it will never happen.
There are several arguments that may validate the hypothesis on a more pro-inflationary
macroeconomic environment in the post-pandemic era as compared to the decade of the 2010s.
In the short term, there are several potentially pro-inflationary factors which should be taken into
consideration. The most important one relates to the monetary overhang (the effect of forced saving –
see Section 2.3) accumulated in 2020. At the moment, it is quite difficult to estimate its actual size and
predict how quickly it can be unfrozen. Putting it in other words, the question is whether the demand

PE 658.221 32
for money will return to its pre-pandemic level and, if yes, how quickly. The rapid increase in asset prices
(Section 3.6) may suggest that the hidden (or repressed) inflationary potential is quite substantial.
The recovery of commodity prices to their pre-pandemic levels (see Figure 14 for oil prices) means that
their deflationary impact observed in 2020 is largely over. There are also first signs of supply-side
bottlenecks, for example, in container transport (Smith, 2021) and semiconductor production (Miller et
al., 2021), which may lead to respective price increases. They confirm the hypothesis that the post-crisis
recovery will not mean a simple reemployment of idle capacities. Rather, the structural changes
induced by the COVID-19 pandemic and lockdown will lead to a certain mismatch between demand
and supply.
There are also concerns related to the size of the fiscal stimulus package proposed by the Biden
administration in the United States and its potential inflationary consequences. Olivier Blanchard, in a
series of tweets17
published on 7 February 2021, argues that the size of the proposed stimulus (USD 1.9
trillion), in addition the Coronavirus Aid, Relief, and Economic Security (CARES) package of USD 900
billion approved by the US Congress in December 2020 and the high probability that consumers will
spend USD 800 billion out of the excessive saving accumulated in 2020, gives a total amount of USD
3.6 trillion of additional effective demand, while the upper bound estimation of the output gap in the
United States is USD 900 billion – that is, four times less. Summers (2021) raised similar concerns and
arguments. Interestingly, both authors downplayed the inflation risk and called for a more active fiscal
policy not so long ago.
Going beyond short-term considerations, there are several arguments pointing to potential
inflationary forces in the medium- to long-term. First, deflationary pressures triggered by the
immediate effects of the GFC (serious disruption in financial intermediation) and followed by a new set
of financial regulations (Dabrowski, 2019) will not continue forever. Their potential seemed to reach
their limits in the second half of the 2010s.
Second, according to Goodhart and Pradhan (2020), China’s integration with the world economy since
the 1990s produced a powerful deflationary impact because of its abundant, well-trained, and
inexpensive labour force and high national saving. However, this impact is about to expire or even turn
to the opposite, largely due to demographic changes in China (shrinking working age population and
population ageing) and its maturing economy. Similar demographic changes in AEs will work in the
same, inflationary direction (Bartsch et al., 2020).
Third, tensions in the world trade system triggered by the protectionist policies of the United States
under President Donald Trump may also produce inflationary consequences if continued. At the time
of writing this paper, it remains unknown whether the new US administration of President Joseph
Biden will conduct more pro-trade policies than its predecessor. However, one can assume that
substantial progress in the liberalisation of world trade like that observed in the 1990s and early 2000s
is very unlikelyin the near future. The continuation of the downward pressure on the prices of tradeable
goods and services generated in the previous 30 years by global competition is very unlikely (Bartsch
et al., 2020; Goodhart and Pradhan, 2020).
Fourth, the rapid deterioration of fiscal balances and the growing public debt have an inflationary
character in the long term. Furthermore, they constrain a CB’s room for manoeuvre in fighting inflation.
This issue will be further discussed in Section 4.2.
17 See Olivier Blanchard, https://twitter.com/ojblanchard1/status/1358122336432648192.

33 PE 658.221
4.2. Increasing fiscal dominance
The analysis presented in Sections 2.4 and 3.7 show the narrowing fiscal space in most AEs, which has
been temporarily relaxed only by ultra-loose monetary policies conducted via large purchases of
government securities and de facto public debt monetisation. This has led to an increasing fiscal
dominance (Landau, 2021) or, using other words, an increasing monetary policy dependence on fiscal
policy. In practice, CBs may become hostages of fiscal authorities and the inability or unwillingness of
governments to carry out a necessary fiscal adjustment on time18
. In turn, this may create a serious
obstacle to monetary policy tightening and reversing QE when inflation pressure comes back.
In such circumstances, CBs will be confronted with an increasingly dramatic dilemma. Fulfilling their
price stability missions will require first stopping the APPs and then reducing their balance sheets, on
the one hand, and hiking interest rates, on the other (Blanchard, 2020). However, both will lead to an
increase in the government’s interest payments and a further deterioration of its fiscal position, other
things being equal. Some governments may face the risk of sovereign insolvency which, in turn, will
undermine the stability of the financial sector (see Section 4.3) and boost inflationary expectations.
On the other hand, giving in to fiscal pressures would lead to higher inflation and undermining thus far
stable inflationary expectations (Landau, 2021), which has constituted a stable anchor to both
monetary and fiscal policies in major currency areas since the mid-1990s. Higher inflation could
perhaps depreciate the real stock of public debt (i.e., if it had an unexpected character), but other
economic and social consequences would be negative.
Unfortunately, the ongoing process of updating monetary policy strategies (completed by the Fed,
unfinished by the ECB) seems to go towards creating formal excuses for higher inflation by the
mechanism of making up past inflation “underperformance”.
The new version of the “Statement on Longer-Run Goals and Monetary Policy Strategy” (FOMC, 2020)
announced by the Fed on 27 August 2020 reinterpreted the inflation target of 2% as a longer-term
average, which means that “…following periods when inflation has been running persistently below 2
percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for
some time.” With all the imprecision of this declaration (what does “moderately above 2percent” and “for
some time” mean exactly?)19
, it looks like giving price stability less attention in the future in favour of
other declared (maximum employment, moderating long-term interest rates) or undeclared policy
goals (for example, easing fiscal constraints).
In January 2020, the ECB also launched the process of its monetary policy strategy review, its first since
2003. At the time of writing this paper, it is still an ongoing process scheduled to be concluded in 2021.
However, the public address of ECB President Christine Lagarde on 30 September 2020 in which she
mentions the need for “symmetry” in regard to the inflation target and discusses the possibility of
making up for inflation misses (Lagarde, 2020) may suggest a similar approach to the Fed’s strategy
revision.
The expert debate, which accompanies the process of the ECB strategy review, brings even more
radical proposals like, for example, increasing the inflation target to accommodate structural changes
in the economy originating from the EU’s decarbonisation policy (Rey, 2020).
18 The broad critique of the supposed fiscal austerity in the 2010s in the United States, euro area and UK (see e.g., Krugman, 2015; Skidelsky,
2015) and the disregard for fiscal sustainability constraints will not help in timely decisions to stop fiscal expansion and taking the
necessary fiscal adjustment measures.
19 Being such an imprecise formula itself may create higher inflationary expectations – see Bartsch et al. (2020).

PE 658.221 34
Overall, the increasing fiscal dominance may undermine CB independence, the fundamental
institutional achievement of the last two decades of the 20th
century (Landau, 2021), which can be
considered from a historical perspective as the equivalent of the metallic standard or hard peg.
Unfortunately, in the context of increasing fiscal dominance, there are experts who are ready to
recommend monetary accommodation by increasing PSBRs and who consider CB independence as an
illusion (see Buiter, 2020; 2021).
4.3. Risks to financial stability
Risks to financial stability is another potential challenge that deserves the serious consideration of both
governments and monetary authorities. On the one hand, painful lessons and memories from the GFC
and the resulting financial regulation and supervision reforms in the 2010s made the financial sector
more stable and resilient to adverse shocks. However, on the other hand, the COVID-19 crisis has
generated new risks and uncertainties. In particular, banks and non-banking financial institutions can
become victims of asset bubbles, especially in the housing and stock markets (see Section 3.6), and
recession. While in 2020 the number of enterprise insolvencies (clients of commercial banks) did not
increase due to various governmental support schemes (Claeys et al., 2021), the situation may change
in 2021 and subsequent years for the worse. It will result in an increasing share of non-performing loans
and deteriorating financial results and balance sheets for banks. Bank profitability has also been
negatively influenced by very low market interest rates and negative CB interest rates. In addition, low
interest rates may distort credit allocation in favour of the so-called “zombie” firms (i.e., those without
a viable market perspective) and further deteriorate the quality of banks’ assets.
The increasing risks to financial stability may pose a serious challenge to CBs both in their role of
financial supervisors and institutions responsible for financial stability (all three CBs analysed in this
paper are mandated with such a role) and as monetary authorities. Any potential incidence of financial
instability may have a negative impact on monetary stability. In addition, the necessity to rescue the
financial sector, especially banks, may stay in conflict with monetary policy objectives and their price
stability mandate (see Cukierman, 1996; Dall’Orto Mas et al., 2020).

35 PE 658.221
5. CONCLUSION
The economic crisis caused by the COVID-19 pandemic has been the second global adverse shock of
this size in the 21st
century, after the GFC of 2007-2009. However, its economic characteristics are
different from the GFC and other financial crises and business cycle downturns. While the GFC
generated a powerful deflationary shock due to far-reaching disruption in financial disintermediation
and then the new regulatory regime in the financial sector, the COVID-19 crisis is a combination of
supply- and demand-side disruptions caused by anti-pandemic containment measures, massive
uncertainty, and the resulting precautionary behaviour of both consumers and investors. This leads to
the phenomenon of forced (involuntary) saving and the building up of a monetary overhang.
However, disregarding differences between both crises, governments and CBs reacted to the current
crisis in a similar way as 12 years earlier, that is, by massively relaxing both fiscal and monetary policies.
While the necessity of some forms of fiscal and monetary support (to fight the pandemic, compensate
for the lockdown, supply the financial sector with sufficientliquidity, and helpeconomies outside major
currency areas) has been out of question, the idea of the aggressive and untargeted boosting of
aggregate demand by fiscal and monetary measures in the time of lockdown restrictions raises serious
doubts. First of all, it is very costly, especially when most governments entered the COVID-19 crisis
without sufficient fiscal buffers.
Similarly, CBs in AEs did not manage to withdraw from UPMs, stop QE, reduce their balance sheets, or
increase interest rates above zero in the second half of the 2010s (the Fed was a partial exception)
(Dabrowski, 2019). Therefore, after the outbreak of the COVID-19 crisis, they had only one method of
monetary policy easing left – the further intensification of APPs. However, as already experienced in
the 2010s, QE has numerous shortcomings and undesired side effects20
. One concerns the adverse
impact of QE on financial intermediation and the monetary transmission mechanism. The additional
monetary base is not fully absorbed by commercial banks and does not reach their clients – enterprises
and households. The reason being that banks prefer to keep a substantial part of their additional
liquidity in the form of voluntary deposits with CBs (despite negative interest rates).
Another problem relates to the monetary-fiscal nexus. Conducting a mass-scale QE, CBs must rely on
purchasing government bonds because of a shortage of other assets of sufficient quality and liquidity.
However, this leads to an increasing monetary policy dependence on fiscal policy (fiscal dominance)
and, by decreasing yields on government bonds, weakens government incentives to conduct a
prudent fiscal policy. On the contrary, it creates the expectation of low interest rates in the long term –
an illusion of a “free lunch” – which is far from reality (Rogoff, 2020). Actually, it only delays the moment
of truth when governments are confronted with fiscal sustainability constraints. This is the challenge
faced not only by EM economies. Governments of AEs, including those which have global currencies,
are not fully free of them as demonstrated, for example, by the fiscal crisis at the euro area periphery in
the first half of the 2010s.
For CBs, such an ever closer “symbiosis” between monetary and fiscal policies can mean the dramatic
narrowing of their room for policy manoeuvre and the de facto compromising of their independence.
This may happen when CBs should tighten monetary policy to resist inflationary pressures. Because
each form of tightening (stopping QE, reducing CB balance sheets, and hiking CB interest rates, among
others) will create upward pressure on government bond yields, it can lead to an open conflict between
CBs and the executive and legislative branches of government (Goodhart and Pradhan, 2020). Again,
something that has been experienced on numerous occasions by CBs in EM economies may also
20 See Hartwell (2018) and Siklos (2020) for overviews of the successes and failures of QE.

PE 658.221 36
become a reality in AEs, even those with the advanced institutional safeguards of CB independence
like in the euro area.
This is not a purely hypothetical scenario. The reversal of a more than a decade-long deflationary
pressure may come sooner than many tend to think, for a number of reasons. In the short term, it may
originate from the unfreezing of the monetary overhang formed during the pandemic, demand-supply
mismatches resulting from pandemic-induced structural changes, and overshooting monetary and
fiscal stimulus packages, to mention only a few. In the medium- to long-term, inflationary pressures
can result from the expiring deflationary impulses of the 2010s (related to the legacy of the GFC and
tighter financial regulations), demographic changes, deglobalisation, and the deterioration of fiscal
balances.
Governments and CBs should think ahead about how to avoid a policy trap caused by a rapidly growing
public debt and its de facto monetary financing, especially in the context of the potential return of
inflationary pressures. With no doubt, balancing short-term needs (especially in times of emergency)
and long-term constraints and challenges is an art of policymaking (see Landau, 2021). Such an art is
badly needed in the current situation, especially if fighting the COVID-19 pandemic is going to take
longer and cost more than originally expected.

37 PE 658.221
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PE 658.221
IP/A/ECON/2021-07
PDF ISBN 978-92-846-7854-9 | doi:10.2861/26448 | QA-02-21-265-EN-N
The economic characteristics of the COVID-19 crisis differ from those of previous crises. It is a
combination of demand- and supply-side constraints which led to the formation of a monetary
overhang that will be unfrozen once the pandemic ends. Monetary policy must take this effect into
consideration, along with other pro-inflationary factors, in the post-pandemic era. It must also think
in advance about how to avoid a policy trap coming from fiscal dominance.
This paper was provided by the Policy Department for Economic, Scientific and Quality of Life
Policies at the request of the committee on Economic and Monetary Affairs (ECON) ahead of the
Monetary Dialogue with the ECB President on 18 March 2021.

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