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A risk-centric perspective on the central banks’ Covid-19 policy response

The Covid-19 shock has caused large turmoil on financial markets. This column argues that non-financial supply shocks such as the current one can endogenously lead to financial shocks and severe contractions in asset valuations and aggregate demand, which substantially amplify a recession. Conventional monetary policy can mitigate the downward pressure as long as the interest rate is unconstrained. If it is, large-scale asset purchases by government facilities are needed to prevent a downward spiral.

While the Covid-19 shock is primarily a real shock, it also had a large impact on financial markets. Figure 1 illustrates that (perceived) stock market volatility spiked to levels comparable to those during the Global Crisis of 2008-2009. Other indicators of financial distress exhibited similar patterns— investment grade and high yield spreads tripled, and the S&P 500 dropped by 30% in a matter of weeks (a drop, per unit time, larger than the worst drop during the Great Depression). The Fed (with the backing of the Treasury) had to pledge close to 20% of US GDP in funding for a wide range of credit and market supporting facilities to stop the free fall. Central banks in the Group of Seven countries purchased $1.4 trillion of financial assets in March alone. And the final story is yet to be told.

Figure 1 CBOE Volatility Index (VIX)

The central banks’ policies have benefited asset holders but a political backslash is brewing (see the Wall Street Journal’s Editorial on 16 April).  Is this just another bailout policy that ignores Main Street in favour of Wall Street? We argue that it is not. In fact, even if the only concern of policymakers is the wellbeing of Main Street, the central banks’ policies are appropriate and crucial for supporting aggregate demand.

Before the Global Crisis, many macroeconomists held the view that while financial markets might reflect economic activity, they typically do not have a large causal impact on the business cycle. The Global Crisis and the subsequent research shattered these beliefs. A large empirical literature has highlighted that the price of risky assets ---such as credit, housing-backed securities, housing, and stocks---can directly and substantially affect aggregate demand (spending by firms and households). An increase in the credit spreads reduces investment and consumption (Gilchrist and Zakrajšek 2012), a decline in house prices reduces consumption as well as employment in sectors that see a reduction in their demand (Mian and Sufi 2014). Stock prices---which are usually thought to be the most detached from real economic activity---also affect consumption and employment (Chodorow-Reich et al. 2019). Through these and other channels, a decline in risky asset prices often lowers aggregate demand and induces the Fed to cut interest rates (Pflueger et al. (forthcoming)).

In a recent paper (Caballero and Simsek forthcoming), we develop a risk-centric macroeconomic model that parsimoniously captures the relationship between risky asset prices and aggregate demand. The model is a variant of the New Keynesian model, but is formulated in terms of a risk-centric decomposition. Specifically, we decompose the demand block into two relations: an output-asset price relation that captures the positive association between asset prices and aggregate demand and a risk balance condition that describes asset prices given risk, risk attitudes, beliefs, and the interest rate. This decomposition makes it easier to study the macroeconomic impact of a variety of forces that affect risky asset prices. The decomposition also emphasizes that monetary policy affects the economy through its impact on financial markets and asset prices. Conventional monetary policy ensures that the interest rate is sufficiently low to induce sufficiently high asset prices that align aggregate demand with potential output. When the interest rate policy is constrained, shocks that lower asset valuations drag the economy into a demand recession.

In Caballero and Simsek (2020), we apply our framework to the recent Covid-19 episode. We show that non-financial supply shocks (e.g. a Covid-19 shock) can endogenously lead to financial shocks consisting of severe contractions in asset valuations and aggregate demand that can substantially amplify the recession. Our mechanism relies on heterogeneity in investors’ risk tolerance. Specifically, we split investors into risk-tolerant and risk-intolerant agents. We dub the risk tolerant agents ‘banks’  -- interpreted broadly to include the shadow financial system and other agents able/willing to hold substantial financial risk -- and the risk intolerant ones ‘households’. The key implication of this assumption is that banks are levered in equilibrium, and they therefore are highly exposed to aggregate supply shocks and the sequence of events that these shocks may trigger.

To fix ideas, consider a large negative supply shock. This shock exerts downward pressure on risky asset prices (which include credit, housing, and stocks, among others). As banks incur losses, their leverage rises. With higher leverage, banks require a higher Sharpe ratio (risk premium per unit of risk) to hold risky assets. Further, risk-intolerant households also require a higher Sharpe ratio to hold the risky assets unloaded by banks wishing to reduce their leverage. The result is a decline in the market’s effective risk tolerance that increases the required Sharpe ratio. When the banks' initial leverage is high (or the supply shock is sufficiently large, as in the case of Covid-19), the decline in effective risk tolerance exerts substantial downward pressure on asset prices and aggregate demand that exceeds the initial downward pressure from the decline in supply. In particular, the supply shock ultimately reduces ‘rstar’­­­­­—the interest rate that ensures output is equal to its supply-determined potential.

The first line of defence against such a shock is conventional monetary policy that cuts the interest rate (consistent with lower ‘rstar’). This directly increases the risk premium and provides the market with the greater Sharpe ratio that it requires, thus relieving the downward pressure on asset prices. Asset prices and aggregate demand decline in proportion to the reduction in supply but no more. However, if the interest rate is constrained, then asset prices decline beyond the direct impact of the reduction in supply.  These lower asset prices then generate a demand recession and output falls beyond the reduction in potential output. To make matters worse, the amplified decline in asset prices further exacerbates banks’ losses (and raises their leverage), which further reduces risk tolerance and depresses asset prices, triggering a downward spiral. We show that when banks' initial leverage is sufficiently high (or the shock sufficiently large), the feedback between asset prices and risk intolerance becomes so strong that multiple equilibria are possible. In the worst of these equilibria, banks go bankrupt.

This description of events suggests that policies where the consolidated government (e.g. the Fed and the Treasury in the US) absorbs some of the risk that banks are struggling to hold can be highly effective at boosting aggregate demand and mitigating recessions. We loosely refer to these policies as large-scale asset purchases (LSAPs). We show that, to the extent that the government has future fiscal capacity, LSAPs are powerful because they reverse the downward spiral. That is, they exhibit a high multiplier precisely when the economy is most unstable. We further show that it is optimal for the government to deploy LSAPs when the aggregate demand amplification of the supply shock is severe, even if the government is less risk tolerant than the market.

It is important to clarify that the LSAPs in our model are different from bank bailouts. While LSAPs support banks indirectly (and this is why they are powerful), they are not a direct handout to banks. In fact, governments earn a positive return (the risk premium) on the asset purchases, so future taxpayers on average see their taxes decline—although there are states of the world in which taxes increase (hence the need for future fiscal capacity). More importantly, by mitigating the recession, LSAPs increase both income and wealth of all current agents, including the households. That is, policies such as LSAPs that support asset prices should be viewed as an essential complement to the Main Street facilities that directly support households and non-financial firms. Without LSAPs (or a similar policy response), the shock could lead to a financial downward spiral that would require a much larger Main Street intervention.

In the Covid-19 episode, the spike in VIX (and in all the other indicators of financial distress) began to reverse after the central banks’ policy actions (Figure 1), which suggests that the interventions have been effective in preventing the downward spiral. Only time will tell whether the Covid-19 shock is more persistent than we currently hope, and whether new LSAPs will be required to prevent a financial crisis and support aggregate demand.


Caballero, R J and A Simsek (forthcoming), “A risk-centric model of demand recessions and speculation, Quarterly Journal of Economics.

Caballero, R J and A Simsek (2020), “A Model of Asset Price Spirals and Aggregate Demand Amplification of a “Covid-19” Shock,” CEPR discussion paper No. 14627.

Chodorow-Reich, G, P T Nenov and A Simsek (2019), “Stock market wealth and the real economy: A local labor market approach,” NBER working paper No. 25959.

Gilchrist, S and E Zakrajšek (2012), “Credit spreads and business cycle fluctuations”, American Economic Review, 102:1692-1720.

Mian, A and A Sufi (2014), “What explains the 2007–2009 drop in employment?”, Econometrica, 82: 2197-2223.

Pflueger, C, E Siriwardane and A Sunderam (forthcoming), “Financial Market Risk Perceptions and the Macroeconomy”, Quarterly Journal of Economics.

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