Monetary policy pushing new limits - Capital Economics
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Monetary policy pushing new limits

Global Central Bank Watch
Written by Jennifer McKeown
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What a difference a month makes. At the time of our last Global Central Bank Watch, monetary policymakers in advanced economies had taken a cautious but relatively sanguine attitude to the coronavirus and made only small policy changes. Now, they have pulled out just about every stop.

  • Rates slashed to rock bottom and generosity of lending enhanced
  • Massive asset purchases are intended to boost liquidity and will be reduced in time
  • But radical sustained support seems possible, carrying future inflation risks for some

What a difference a month makes. At the time of our last Global Central Bank Watch, monetary policymakers in advanced economies had taken a cautious but relatively sanguine attitude to the coronavirus and made only small policy changes. Now, they have pulled out just about every stop.

Chart 1 shows how interest rates have been slashed to rock bottom (or very close) in the advanced economies where there was any scope to cut.

Chart 1: Key Policy Interest Rates (%)

Source: Refinitiv

The generosity and potential size of central bank lending programmes has been increased to levels never seen before. The Fed has established a range of new credit facilities in collaboration with the US Treasury, which could feasibly support up to $4tn of new financing to firms and households. The ECB is offering unlimited loans to commercial banks at the deposit rate of -0.5% and targeted loans (conditional on lending to the private sector) at -0.75%. The Bank of England has increased the amount banks can borrow from its Term Funding Scheme with incentives for Small and Medium-sized Enterprises (TFSME) from 5% to 10% of their outstanding loans, suggesting that the amount borrowed could end up being over £200bn. And the Bank is expected to start providing loans directly to businesses soon via the new Covid-19 Corporate Financing Facility.

What’s more, asset purchases have resumed in the US, euro-zone and UK, while new programmes have been launched in Australia and Canada. Chart 2 shows the size of current monthly asset purchases as shares of GDP in each case. The US is far in the lead, with the Fed buying around $900bn of Treasury securities and $300bn of mortgage-backed securities in the last two weeks of March alone. At that rate, the monthly pace looks set to be around 10% of GDP, far exceeding the purchases made at the peak of the financial crisis. The ECB’s purchases look small in comparison – we estimate that it is buying around €100bn of government bonds per month. But this is also a faster pace than ever before.

Chart 2: Current Monthly Pace of Asset Purchases
(% of GDP)

Sources: Refinitiv, Central banks, Capital Economics

It is important to distinguish these asset purchases from those undertaken during rounds of quantitative easing in 2009 and the mid-2010s. For the Fed in particular, the purchases aim to provide liquidity rather than to reduce long-term bond yields or encourage portfolio rebalancing, which are the typical aims of QE. The ECB is also focused on financial stress, but in the form of rising borrowing costs for southern economies. It has therefore pledged to skew its buying in favour of those states if necessary. The Bank of England, Bank of Canada and Reserve Bank of Australia have also all stressed that their new purchases are aimed at providing liquidity and easing money and financial market tensions. But, intentionally or not, the government bond purchases have also facilitated the large fiscal stimulus packages that almost all governments have announced.

One key implication of the stated aim to ease financial market strain is that the asset purchases are unlikely to go on for very long, at least not at this pace. Indeed, the RBA stated as much following its meeting this month. (See here.) Once the coronavirus has been brought under control, market tensions should ease and policy should revert to something more like normal. Chart 3 shows our forecast for the combined monthly asset purchases of the Fed, ECB, Bank of Japan and Bank of England. Current purchases far surpass anything that we have seen before. But we assume that they will taper off very quickly, albeit less so in the euro-zone where strains in peripheral economies are likely to persist and where we had anticipated renewed asset purchases to address low inflation even before the crisis began.

Chart 3: Major Advanced Economy Asset Purchases ($bn)

Sources: Central banks, Capital Economics, Refinitiv

Policy support has of course not been confined to the advanced economies – many EMs in Asia began to cut interest rates several weeks ago. Support has since spread more widely, with the central banks of South Africa and India cutting by 100bps and 75bps respectively. Several EMs have even launched asset purchase programmes, which would have been hard to imagine just a month or so ago. Note, though, that these are also aimed primarily at reducing credit spreads and stabilising the financial system rather than conventional QE-style loosening. (See this Emerging Markets Economics Update.)

So what will be the effects of all this? Central banks cannot hope to prevent deep recessions in the near term given that many types of economic activity have been shut down. We are now projecting quarterly falls in output of as much as 20% in Q2 in euro-zone economies, for example. However, their support is clearly having an effect. Most obviously, central bank bond purchases and liquidity provision have helped to ease strains in financial markets. We outline the effects in detail in our Financial Market Stress Monitor. But in short, forced selling of safe bonds has eased, allowing yields to track equity prices down as they usually would in a downturn. (See Chart 4.) The gap between 3-month secured borrowing rates and the T-bill yield has closed and equity prices have stabilised.

Chart 4: S&P 500 & 10-Year US Treasury Yield (%)

Source: Refinitiv

What’s more, it is to be hoped that the measures being adopted by central banks now can help to support a recovery once the virus has been brought under control. Lending operations can help to keep firms afloat, limiting layoffs and allowing them to resume business once they are permitted or when demand is back.

Future monetary policy will depend heavily on how this shock evolves. If it turns out that the economic disruption is largely temporary, then asset purchases will taper sharply as our forecasts imply. (Indeed, Fed purchases have already started to slow.) But we doubt that interest rate hikes are in prospect for some time. Similarly, asset sales seem unlikely due to the risk of destabilising markets again.

If the weakness of economic activity proves longer-lived, perhaps because government support measures and central bank loans are unable to prevent layoffs and insolvencies, then there are several ways that monetary policy support could be extended. Most obviously, large asset purchases could go on for longer than we have assumed. Alternatively (or perhaps additionally), there could be a shift to “yield curve control”, where the banks target a specific level of bond yields at a given maturity. The Bank of Japan has been doing this for some time and the Reserve Bank of Australia launched a target for three-year government bond yields in mid-March. An explicit pledge to keep yields below a certain level might boost the effectiveness of asset purchases.

It is only a small step from there to full-blown helicopter money. Central banks’ intentions now might be to boost liquidity and ease financial market strains. But still, their policies are reducing government borrowing costs at a time of huge fiscal stimulus. (See this Global Economics Update for more on fiscal programmes.) Prolonged purchases would start to look a lot more like monetary financing. The remaining hurdle would be for banks to buy directly from governments at issuance, financed by a permanent rise in central bank money with no associated rise in government debt. (See this Global Economics Focus for more.) We have yet to forecast such a policy, but it seems increasingly likely in Japan where monetary policy is at its limits and the government feels constrained in its fiscal response by a particularly heavy debt load. (See our Japan Economics Update.)

In all, central banks’ bold actions are helping to prevent a devastating near-term shock to the global economy from morphing into a financial collapse or a sustained economic depression. But there is a major challenge ahead in deciding how much policy support will be warranted to bring demand back to normal. For now, the major threat seems to be deflation. Note, after all, that even long-term inflation expectations have fallen to very low levels. (See our Global Inflation Watch for more.)

But it is possible that the support will prove to be inflationary in future. It would be easy to mistake any permanent reduction in the economy’s supply potential for a shortfall in demand, leading to undue policy stimulus over the next couple of years. More fundamentally, it’s possible that some governments may start to view inflation as a way of reducing the burden of debt accumulated as a result of the current crisis. Of course, this would require a wholesale change to the mandate given to advanced economy central banks. What’s more, Japan’s experience suggests that inflation is hard to generate. But for some emerging economies, including Brazil and Poland, the threat that monetary financing will cause runaway inflation is closer and more severe.

Monetary policy overview by major central bank

Since our last Global Central Bank Watch, interest rates have been slashed across most of the world. Of the 20 central banks covered in this report, only Denmark’s Central Bank increased its key policy rate, while around three-quarters cut interest rates at least once and, in some cases, multiple times. (See Chart 5.) In many instances, interest rates are now at record lows, including in the US, euro-zone, the UK, Canada, Australia, and India.

Chart 5: Changes in Benchmark Rates

Sources: Bloomberg, Capital Economics

Looking ahead, we expect that monetary policy will continue to be loosened in most economies this year. (See Table 1.)

Table 1: Summary of CE Forecasts for Policy Rate
Net Changes by the End of 2020

Policy

Direction

Economies

Easing

Euro-zone, Japan, Switzerland, Sweden, Denmark, New Zealand, India, Brazil, Mexico, South Korea, Poland, South Africa

No Change

UK, US, Canada, Australia, Norway, China

Tightening

Turkey

Source: Capital Economics

Admittedly, with most DMs at, or close to their floor, any rate cuts will be fairly small. We suspect that the Fed has already reached its floor. The ECB has so far kept its deposit rate on hold at -0.50%, but we expect a further 20bp cut later this year to -0.70%. The Bank of Japan is set to cut by 10bps to -0.2%, the SNB to cut by 25bps to -1% and the Riksbank to reverse course and cut its repo rate by 25bps back to 0.25%. Following these cuts, interest rates will then most likely stay on hold over the rest of the forecast period in most advanced economies. But unconventional monetary policy tools will continue to be used where rates are judged to be at the effective lower bound.

With the exceptions of the US and Australia, our interest rate forecasts are typically marginally lower than those implied by financial markets. New Zealand is the outlier. The Reserve Bank of New Zealand had previously stated that negative interest rates would be its unconventional monetary policy tool of choice. We expect the RBNZ to implement negative interest rates later this year, with the first 25bps cut in August. In total, we expect 100bps of cuts to -0.75% – far below what is priced in by investors. (See Chart 6.)

Chart 6: Change to Policy Rates by End-20 Implied by OIS Markets & CE Forecasts (%)

Sources: Bloomberg, Capital Economics

Interest rates have been slashed in EMs too. Brazil, South Korea, Mexico and Poland have all cut their respective interest rates by 50bps, while South Africa has reduced the repo rate by 100bps. With interest rates higher in most emerging economies, policymakers will be able to make deeper cuts over the rest of the year. Of the main emerging economies, Brazil looks set to reduce its policy rate by 50bps, Mexico by 100bps, South Korea by 25bps, Poland by 50bps and South Africa, 75bps.

In China, the 7-day repo rate was cut by 20bps to a record low in March. While the 7-day repo rate will probably remain on hold for the remainder of this year, we expect the PBOC to loosen policy further. Short-term repo rates have fallen by 80bps since the start of the year and look set to fall by at least 20bps in the coming months. And we expect the PBOC to cut benchmark deposit rates before long.

Table 2: Central Bank Policy Rates

Country

Policy rate

Latest

Last Change

Next Change

(CE Forecast)

End-2019

End-2020

End-2021

Major Advanced Economies

US

Fed funds target

0.00-0.25

Down 50bp (3rd Mar. 2020)

Down 100bp (15th Mar. 2020)

None on horizon

1.50-1.75

0.00-0.25

0.00-0.25

Euro-zone

Deposit rate

-0.50

Down 10bp (Sep. 2019)

Down 20bp (Q2 2020)

-0.50

-0.70

-0.70

Japan

Interest on excess reserves

-0.10

Down 10bp (Jan. 2016)

Down 10bp (Q2 2020)

-0.10

-0.20

-0.20

UK

Bank Rate

0.10

Down 50bp (11th Mar. 2020)

Down 15bp (19th Mar. 2020)

None on horizon

0.75

0.10

0.10

Other Advanced Economies

Canada

Overnight target rate

0.25

Down 50bp (4th Mar. 2020)
Down 50bp (16th Mar. 2020)

Down 50bp (27th Mar. 2020)

None on horizon

1.75

0.25

0.25

Australia

Cash rate

0.25

Down 25bp (3rd Mar. 2020)

Down 25bp (19th Mar. 2020)

None on horizon

0.75

0.25

0.25

Switzerland

Sight deposit rate

-0.75

Down 50bp (Jan. 2015)

Down 25bp (Q3 2020)

-0.75

-1.00

-1.00

Sweden

Repo rate

0.00

Up 25bp (Dec. 2019)

Down 25bp (Q3 2020)

0.00

-0.25

-0.25

Denmark

Deposit rate

-0.60

Up 15bp (20th Mar. 2019)

Down 10bp (Q3 2020)

-0.75

-0.80

-0.80

Norway

Sight deposit rate

0.25

Down 50bp (13th Mar. 2020)
Down 75bp (20th Mar. 2020)

None on horizon

1.50

0.25

0.25

New Zealand

Cash rate

0.25

Down 75bp (16th Mar. 2020)

Down by 25bp (Q3 2020)

1.00

-0.75

-0.75

Major Emerging Economies

China

7-day reverse repo rate

2.20

Down 10bp (3rd Feb. 2020)

Down 20bp (30th Mar. 2020)

Up 5bp (H2 2021)

2.30

2.20

2.25

India

Repo rate

4.40

Down 75bp (27th Mar. 2020)

Down 40bp (Q2 2020)

5.15

4.00

4.50

Brazil

Selic rate

3.75

Down 50bp (1st Mar. 2020)

Down 50bp (May 2020)

4.50

3.25

3.25

Russia

1-week repo rate

6.00

Down 25bp (Feb. 2020)

Down 25bp (May 2020)

6.25

5.00

5.00

Mexico

Overnight target rate

6.50

Down 50bp (20th Mar. 2020)

Down 50bp (May 2020)

7.25

4.50

4.50

South Korea

Base rate

0.75

Down 50bp (16th Mar. 2020)

Down 25bp (Q2 2020)

1.25

0.50

0.50

Turkey

1-week repo rate

9.75

Down 100bp (17th Mar. 2020)

Down 100bp (Apr. 2020)

13.00

10.75

14.25

Poland

Reference rate

1.00

Down 50bp (17th Mar. 2020)

Down 50bp (Apr. 2020)

1.50

0.50

0.50

South Africa

Repo rate

5.25

Down 100bp (19th Mar. 2020)

Down 50bp (May 2020)

6.50

4.50

4.50

Sources: Bloomberg, Capital Economics.

Table 3: Quantitative Easing & Other Unconventional Policies

Sources: Central banks, Capital Economics. *Latest

Table 4: Calendar of Policy Decisions

Sources: Bloomberg, Capital Economics


Jennifer McKeown, Head of Global Economics Service, jennifer.mckeown@capitaleconomics.com
Gabriella Dickens, Assistant Economist, gabriella.dickens@capitaleconomics.com