There is much more that central banks could do to ease any strains that appear in financial markets. But with interest rates now more or less back to their effective lower bound in the US, euro-zone, Japan and the UK, monetary policy appears to be operating at the limits of what it can do to stimulate demand. The responsibility for providing lasting support for aggregate demand now sits squarely with fiscal policy.
- There is much more that central banks could do to ease any strains that appear in financial markets. But with interest rates now more or less back to their effective lower bound in the US, euro-zone, Japan and the UK, monetary policy appears to be operating at the limits of what it can do to stimulate demand. The responsibility for providing lasting support for aggregate demand now sits squarely with fiscal policy.
- One point to stress from the outset is that the ability of central banks and governments to “put a floor” under stock markets is limited. As we have noted before, history suggests that equity markets are only likely to bottom out when it becomes clear that the flow of new cases of the virus has peaked.
- But that doesn’t mean that policymakers are impotent. Instead, it all depends on what they are trying to achieve. Three potential objectives stand out, with different tools needed to meet each.
- The first is to prevent the dislocation in financial markets over the past week from developing into a severe liquidity squeeze. Responsibility for this lies squarely with central banks. In general any measures will fall into one of two camps. The first involves targeting particular pockets of illiquidity, such as the expansion of foreign currency swap lines announced last night by the world’s major central banks. The second involves flooding the system with liquidity by expanding banks’ reserves at the central bank (this would have the look and feel of quantitative easing). Both could in theory be done without limit if required.
- The second objective is to provide short-term assistance to those affected directly by the economic disruption caused by measures to contain the virus. This requires a response from both central banks and governments. Central banks can offer cheap funding for commercial banks that lend to the hardest hit or most at risk sectors, or even make funding directly available to the non-financial corporate sector and possibly households. But fiscal policy has a bigger role to play. This encompasses everything from the expansion of access to healthcare and increases in government-funded sick pay to tax breaks for businesses and one-off payments to households. Governments can also guarantee cheap loans made to the hardest hit (but otherwise solvent) firms or – in the extreme – assume the liabilities of private companies.
- It’s worth noting, however, that these measures – both monetary and fiscal – will at best only cushion the economic effects of the virus. A significant downturn is looming over the coming months, the only question is how deep it becomes. So the third objective is to engineer a more fundamental and longer lasting expansion of demand (in part to head off mounting fears of deflation).
- Responsibility for this now lies more with governments than central banks. This reflects the fact that monetary policy is operating at the limits of what it can do to stimulate demand. (See the updated “Key Themes” section of our website.) There is little scope to drive already low government bond yields even lower. Accordingly, more purchases of governments bonds are unlikely to have much impact on demand. The same is true of “yield curve control” and forward guidance. Central banks could step up purchases of corporate debt, where yields are higher and curves steeper. But this would require some legal changes in some cases and is unlikely to deliver a major boost to aggregate demand. (Read this regarding the US.)
- Instead, the responsibility for delivering a more lasting expansion in demand now sits squarely with fiscal policy. This would be most effective if it was undertaken by countries running large budget and current account surpluses. But there is scope for deficit countries to loosen fiscal policy too. While it is most likely that any immediate fiscal expansions will be debt-financed, governments might eventually have to consider fiscal expansion financed directly by central banks (so-called “helicopter money”).In the past, this has raised all sorts of concerns about blurring the lines between fiscal and monetary policy. But in a world where demand is collapsing, such concerns would be quickly pushed to one side.
Neil Shearing, Group Chief Economist, +44 20 7808 4984, email@example.com