COVID | Monetary Policy & Inflation
There’s been a number of recent papers on the impact of pandemics on economies. A Fed paper looks directly at pandemics going back to the 14th century and finds that they cause real interest rates to fall and wages to go up as a large portion of the labour force dies. A BIS paper models the likely impact of COVID on growth in coming quarters based on assumptions around which parts of the economy will shut down. However, there isn’t much work on the impact on inflation. We therefore delved into the academic literature and found a potentially relevant paper by the ECB on the impact of disasters on inflation.
First Things First
The models are only stable when the Taylor rule features a sufficiently strong long-run reaction to deviations of inflation from target. The nominal policy rate must move more than one-for-one with deviations of inflation from target. Here’s another way to think about it: the real interest rate needs to rise when inflation rises and vice versa.
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