In theoretical terms, the role of central banks is relatively simple: keep inflation at an optimum rate for the economy. Most economists see 2 per cent or its whereabouts as the sweet spot; in Poland, the inflation target has been set at 2.5 per cent +/- 1 percentage point. In regular business cycles, central banks are charged with keeping an eye out for inflation upsurge threats, and duly eliminating the risk usually through moderate interest rate increases. In simple terms, once the economy hits a business cycle low, banks reduce interest rates with intent to lower the cost of credit and stimulate business into investing, sending a development-targeted impulse across the economy. This is what they do when things are normal. It’s just that the times of normality are over.
Central banks are the most powerful analytical centres in the world; by taking advantage of data available to them from all sectors of the economy, they can sometimes respond to phenomena evolving therein with even a head start. Yet the entire analytical mechanism occasionally finds itself helpless in the face of such cataclysms as the COVID-19 epidemic or war. Such events cannot be predicted, with neither economies, business cycle analyses nor econometric models sending out any warning signals. And yet such events tend to ruin the economy, which is why they merit swift and decisive responses.
Interest Rates As a COVID Remedy
The coronavirus which would ultimately cause the pandemic appeared in China at the end of 2019 and a bit later in Europe. Over three years, more than 760 million people would contract COVID-19 worldwide, leaving around 6.9 million dead. Governments took non-standard action to prevent the pandemic from spreading, by introducing lockdowns; drastically restricting travel and traffic in general, use of public transportation included; shutting down large shops and selected companies. In numerous countries, economies simply came to a standstill: the manufacturing industry recorded double-digit declines, as did the GDP of most pandemic-affected countries.
After years of dynamic growth, the Polish economy went into recession, for the first time since 1991. According to Central Statistics Office data, the 2020 GDP dropped by 2.0 per cent year-on-year.
How did central banks respond? The first step was to cut interest rates to give relief to borrowers–households and businesses
The most powerful central bank worldwide, the US Federal Reserve System, was swift in cutting interest rates twice: on 3 March 2020 and 15 March 2020 (the latter an extraordinary Sunday session), by 50 and a further 100 basis points respectively, to a rate of zero (0.00-0.25 per cent), the tempo unprecedented in US history. Such rapid interest rate cuts had never been applied before, even during the financial crisis of 2008.
Rada Polityki Pieniężnej (The Polish Monetary Policy Council) made a decision to reduce NBP’s reference rate by 0.5 percentage points to a 1 per cent level. The successive 0.5 per cent cut was applied in April 2020; by May, the rate was 0.1 per cent.
Narodowy Bank Polski was no exception as interest rates plummeted worldwide. The European Central Bank found itself in different circumstances: since 2014, the Bank had been safeguarding a negative deposit interest rate; consequently, the field for reduction manoeuvres became considerably more limited.
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Bailout Liquidity
The array of instruments available to central banks extends well beyond interest rates. They can buy out Treasury bonds from banks. On one hand, this makes it easier for governments to transfer aid packages to the economy (and at the time of the pandemic they were huge in all countries), providing liquidity in the debt market. In commercial banks, on the other hand, liquid funds are freed up to finance the economy and businesses can tap into them thanks to the fact that interest rates are lowered earlier, thereby lowering borrowing costs.
In April 2020, Narodowy Bank Polski announced that it had been and would be engaging in operations designed to improve the banking sector’s liquidity through repo transactions. In the early stages of the pandemic, in the wake of the first lockdown of 16 March 2020, the Bank was already carrying out an adjustment-targeting repo operation, contributing to the banking sector’s liquidity to the tune of PLN 7.3 billion for a four-day term, declaring readiness for future activities of the kind.
he Bank proceeded to purchase debentures issued or guaranteed by the State Treasury on the secondary market as part of structural open market operations. As proven by annual reports, Narodowy Bank Polski took bonds worth PLN 144 billion off the market over the period of early 2020 until year-end 2022 (just over PLN 100 billion during the period of March–July 2020 alone).
The loosening of NBP’s monetary policy contributed to an easing of financing conditions throughout the economy. In particular, money market rates fell, as did interest rates on loans to the non-financial sector. The central bank’s actions also had an impact lowering yields on government and Treasury-guaranteed bonds, despite a significant increase in public sector borrowing needs in 2020 due to the need for anti-crisis measures, and provided liquidity to the secondary market for these bonds.
On the other hand, banks who had originally purchased said bonds (Narodowy Bank Polski is allowed to buy them on the secondary market only) gained greater liquidity in an impulse to boost the loan campaign, and keep corporate business operations afloat.
In another move intended to improve the financial liquidity of the banking sector, the Monetary Policy Council reduced the required reserve ratio (at 3.5 per cent until 29 April 2020) to 0.5 per cent. In May 2020, the required reserve ratio was further cut to 0.1 per cent. By year-end 2020, the required reserve totalled over PLN 7.5 billion, PLN 37 billion less than one year before. Such was the exact volume of banking sector liquidity increase afforded by the aforementioned instrument. Also in April 2020, NBP launched promissory note loans to refinance commercial bank lending. One such loan was granted in 2020 in the amount of PLN 52.9 million.
Furthermore, banks had other options of making up for shortages and lodging fund surpluses with the central bank in 2020; they could take out lombard loans and end-of-business day deposits, both offered by NBP. Average daily use of both instruments reached PLN 60,000 and PLN 3,193.2 million, respectively.
All central bank activities were designed to keep corporate business operations afloat, allowing companies to survive taxing times thanks to lower costs of business activity financing.
Trillions to the Market
By mid-March 2020, the Fed took action beyond violent interest rate cuts: extraordinary action was taken to secure financial sector liquidity on a global scale. The US central bank launched a campaign co-ordinated with Bank of England, the central banks of Japan, Canada and Switzerland, and the European Central Bank. “A joint move by the world’s top six central banks to increase access to US dollars will help improve liquidity and ease strains in global funding markets”, Bank of England Governor Mark Carney said. A few days before, he had cut the Bank’s key rate from 0.75 to 0.25 per cent as an extraordinary measure.
The programme of feeding economies with capital was running at full speed. Over the period from March until July 2020, the Fed had increased its treasury security purchases by approximately USD 1.7 trillion. From 2019 until year-end 2021, the Fed’s total assets more than doubled: from USD 4.16 trillion to USD 8.79 trillion.
The European Central Bank, on the other hand, introduced its EUR 750 billion Pandemic Emergency Purchase Programme. In June and December 2020, the Programme volume was increased by a further EUR 600 billion and EUR 500 billion, respectively. The move increased the value of the additional quantitative easing package to EUR 1.85 trillion. The EBC’s total assets increased from approximately EUR 4.6 trillion to around EUR 8.5 trillion, i.e. by almost 85 per cent, over the period of 2019 until year-end 2021.
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The banking sector’s reaction was unprecedented, in reflection of unique conditions carrying huge consequences on a formerly unimaginable scale. “While central banks are doing whatever they can to support their economies, they cannot replace active budgetary or industrial policies. The latter will have to help companies adjust to permanent changes caused by the pandemic to manufacturing structures, co-operation systems, and foreign trade relations”, wrote Andrzej Raczko, advisor to the Governor of Narodowy Bank Polski, in the “Obserwator Finansowy” magazine May 2020 edition.
Once the pandemic began subsiding, the global economy’s readiness for recovery became a source of further turbulence.
About Face
Inequalities were on the rise in the global economy during the pandemic crisis. International trade came to a standstill, the manufacturing process put on hold in multiple industries. On the other hand, demand for certain product categories – such as microprocessors – skyrocketed as a result of increased demand for laptops and notebooks; once numerous sectors and the vast majority of the education system had moved online. Locked in their homes, people embarked on a mass campaign of replenishing household appliances, triggering a chain reaction of turbulence to other industries: some automotive companies were forced to restrict or even halt production, having run out of microprocessors. On the other hand, demand for cars plummeted.
Once COVID-related scarcities had passed, a reverse trend struck, companies eager to make up for losses and rebuild inventory as soon as possible. Demand skyrocketed, prices close behind. Inflation-generating supply chain bottlenecks followed. Increased demand for commodities gave rise to shortages of containers and container ships to carry goods from the “world’s factory” – China, and Asia in general. Cases of cost of freight increasing by a factor of eight were recorded.
At the same time, consumers who had refrained from shopping during the pandemic and impatient to make up for the lag made a beeline for shops on the Old Continent and in the US. Given the aforementioned build-up in corporate demand for profit, the combination of all these factors could result in one thing only: rapid increase in inflation.
Another extraordinarily significant inflation-generating factor reared its head in the summer and autumn of 2021: Russia’s hybrid war. Preparing for full-scale aggression against Ukraine, Putin intended to destabilise Europe by using his all-time-favourite weapon: energy. Gazprom had suspended gas supplies to Germany already in July (maintenance works the official reason), threatening an incapacity for guaranteeing gas supplies via Nord Stream 1.
To Ukraine’s Aid
Russia’s war against Ukraine broke out into a full-scale invasion on 24 February 2022. Polish society, state institutions and business came to the aid of refugees, and a nation struggling to defend itself. Narodowy Bank Polski decided to grant the National Bank of Ukraine a swap line of up to PLN 4 billion; following a subsequent request submitted by the Ukrainian bank, the swap was ultimately granted in USD dollars (1 billion). A swap is a mutual currency exchange agreement entered into by two central banks. Pursuant to its terms, Ukraine was able to access hard convertible currency.
In March, NBP, in cooperation with the NBU and PKO BP, launched a special program allowing Ukrainians to exchange hryvnias into zlotys at the official exchange rate, a move of great importance to millions of refugees arriving to Poland: many carried Ukrainian currency only, oversupply causing a nosedive to its exchange office value. Thanks to NBP, every adult Ukrainian national could convert up to UAH 10,000 into Polish zlotys.
“Fleeing the horrors of war, many Ukrainian citizens were forced to go abroad, mainly to Poland. Many refugees only carried hryvnas in cash, running into issues with exchanging them for Polish zlotys. The settlement we signed with NBP resolved the problem”, said Kyrylo Shevchenko, president of the National Bank of Ukraine at the time, on the day the programme was launched.
Fighting Putin-Inflation
The full-blown conflict exacerbated factors which had been pressuring European prices for months. The largest frontline-bordering country, Poland bore the brunt of the phenomena.
Gas and other energy resource prices began climbing swiftly. Even before the war, the average price of oil was 50 per cent higher than the year before, coal more than two and a half times and natural gas almost four times more expensive.
To central banks, this meant one thing and one thing only: the time of intense struggle with inflation – and thus of significant rates increase – was upon them.
Narodowy Bank Polski began a series of interest rate increases in October 2021, raising the reference rate from 0.1 to 0.5 per cent, to ultimately close the series of successive moves in September 2022 at 6.75 per cent. Formally, the Governor of NBP announced the end of the interest rate hike cycle in July this year.
The tightening of monetary policy tightening has proven effective. Inflation dropped from its peak value of 18.4 per cent in February 2023 to 8.2 per cent in September 2023. Forecasts predicting a drop in price increases to single-digit values by September, optimistic outlooks by economists commenting on year-end 2023 inflation, and the persistence of low demand and cost pressures in the economy, as well as limiting inflationary pressures in a weakened economic environment surrounding the Polish economy, prompted the Monetary Policy Council in September to cut the reference rate to 6 per cent, and on 4 October by a further 0.25 percentage points to 5.75 per cent.
All measures are consistent. “Our moves of radically increasing interest rates have resulted in us slightly freezing the economy, direct effects including economic growth slowdown, increased cost of credit, etc. That, however, is temporary”, said Professor Adam Glapiński, Governor of Narodowy Bank Polski, when interviewed by the “Gazeta Polska” daily in May.
“We administered a drug, an ‘injection’ or ’bitter pill’, to treat the patient for fever, and the illness he had been suffering as a result of a violent external shock. Yet if you keep administering drugs for prolonged periods of time, the outcome will not be favourable; you may end up killing the patient, just like Balcerowicz’s ‘reforms’ did. You cannot drive the economy into recession”, Professor Glapiński explained.
On the Road to Normality
The first interest rate reduction since May 2020 was possible thanks to a gradual return to normality in economy in the wake of a series of unpredictable events, which had brought turbulence to multiple natural processes. In all likelihood, the struggle with inflation will extend over coming quarters: paradoxically, it is much easier to go down from 20 to 10 than from 10 to 2,5 per cent, especially given the currently uncertain geopolitical environment.
Today, we have to account for the prospect of a prolonged war on the very doorstep of our eastern border; the threat of an extended recession in Germany – the largest European economy which also happens to be the largest recipient of Polish industrial commodities; the risk of successive price fluctuations on the resource market, if only in connection with the upcoming heating season; and political turmoil, international as well as domestic.
This battle has to be handled with due sensitivity, so as not to lose former achievements, while providing Poles with a sense of security: financial stability on the one hand, employment certainty on the other.