Vaccines won’t preclude looser policy - Capital Economics
Global Economics

Vaccines won’t preclude looser policy

Global Central Bank Watch
Written by Jennifer McKeown

The encouraging news about vaccines has led us to expect most restrictions in advanced economies to be removed by Q2 next year, allowing them to embark on steeper recoveries towards their pre-virus path. But while some have speculated that this will prompt the major central banks to consider policy normalisation, or at least to stop loosening, we disagree. In this Global Central Bank Watch, we outline seven reasons why monetary policy may be loosened further in the coming months and will then remain ultra-loose for several years to come.

  • Central banks keen to bridge a difficult period before vaccines are rolled out…
  • … and reduced fiscal stimulus shifts onus of supporting recovery to monetary policy
  • The legacy of the virus will warrant rock bottom interest rates for several years

The encouraging news about vaccines has led us to expect most restrictions in advanced economies to be removed by Q2 next year, allowing them to embark on steeper recoveries towards their pre-virus path. But while some have speculated that this will prompt the major central banks to consider policy normalisation, or at least to stop loosening, we disagree. In this Global Central Bank Watch, we outline seven reasons why monetary policy may be loosened further in the coming months and will then remain ultra-loose for several years to come.

There is still a difficult period to come

While we hope that vaccines will allow activity to recover more rapidly next year, there is a very difficult period to get through in the meantime. Virus numbers have risen sharply, particularly in advanced economies, and fresh restrictions have been imposed, first in Europe and more recently in the US. These restrictions are typically more targeted, and activity in some sectors – such as manufacturing and construction – will be relatively unaffected. We have therefore argued that second or third wave lockdowns will be far less damaging that those in Q2. However, GDP now looks set to fall in the euro-zone, UK, and some central and Eastern European economies, and the outlook is darkening by the day in the US. Indeed, our Mobility Trackers show that visits to retail sites and workplaces and use of transport have weakened in various DMs.

It would be a mistake to remove support in anticipation of better times to come at a time when businesses are having to shut down and jobs are at risk. Several central bankers have expressed this view, with ECB President Christine Lagarde, for example, saying recently that the economy was “expected to be severely affected by the fallout from the rapid increase in infections and the reinstatement of containment measures, posing a clear downside risk to the near-term economic outlook”. It is for this reason that we actually expect policy to be loosened further next month in the euro-zone and perhaps also the US where there has apparently been a “full range of discussions” around “adjusting [the] parameters” of the asset purchase programme.

Prospect of recovery justifies support now

In fact, the light at the end of the tunnel has arguably strengthened the case to go on supporting businesses now. Some of the key arguments against keeping interest rates low indefinitely are that this can promote the “zombiefication” of economies and prevent the process of creative destruction which allows unsustainable businesses to go under and more promising ones to spring up in their place. If the other side is in sight, then there is a stronger justification for building Ms Lagarde’s bridge.

Credit conditions have begun to tighten

What’s more, evidence that banks have begun to tighten their lending criteria suggests that the case for monetary policy support is now even stronger than it was a few months ago. During the first lockdowns, credit was still widely available and very cheap, so there were limits to what central banks could do to help. Support for closed businesses and displaced workers fell more obviously to governments. But the latest data have revealed that banks in the US, euro-zone, and UK, are restricting the availability of credit on the back of high economic uncertainty and concerns about creditworthiness. (See Chart 1.) With many economies going back into lockdown, banks are likely to become even more cautious.

Chart 1: Bank Business Credit Standards (Net % bal.)

Sources: Refinitiv, Bloomberg, Capital Economics

Accordingly, we suspect that some central banks will make greater use of their lending programmes in the months ahead to ensure that credit continues to flow freely. At its December meeting, the ECB is very likely to announce additional TLTRO operations and it may well make their terms even more favourable for banks. Admittedly, the US Treasury recently decided not to extend the majority of the Fed’s emergency lending facilities beyond the end of the year. But this is unlikely to have a major impact on the economy given that those facilities made up just $25bn of loans. And in the current environment, the decision could raise the likelihood that the Fed will try to provide more stimulus using its other tools, most likely by upping the pace of its asset purchases.

Fiscal stimulus set to be scaled back

The prospect of reduced fiscal stimulus offers further justification for ongoing monetary policy support. Hopes of a major fiscal stimulus in the US have faded since the election failed to deliver the ‘Blue Wave’ that President-elect Joe Biden would have hoped for. Meanwhile, several job support schemes are set to expire in Europe around the spring next year. This may still prove to be too soon for businesses that are getting back on their feet. (See here.)

Spare capacity will linger for some time

Meanwhile, even given the prospect of vaccines boosting activity next year, it seems likely that some spare capacity will persist for a long time to come. A year off work may have caused an erosion of skills for some workers, while others will have been displaced by accelerated structural changes such as the shift to working from home. The extent of any scarring is likely to vary greatly by economy. But while we will be revising up our forecasts for next year for most economies, activity (outside China) will typically still be below its pre-virus path by the end of 2022.

Central banks now more tolerant of inflation

Another factor suggesting that policy normalisation is a long way off is the recent shift in inflation targets, or at least the changing emphasis on how those targets should be interpreted. We discussed the change in the Fed’s policy framework to incorporate an average inflation target in our last Global Central Bank Watch, and also how other central banks had followed suit to some extent. The long and short of it is that central banks will be unlikely to normalise policy pre-emptively, just because it seems likely that inflation will hit their targets in future. Instead, they will wait until inflation has already reached the target on a sustainable basis. And in some cases, they are likely to tolerate or even target a period of above-target inflation to make up for earlier shortfalls.

Higher debt levels will require financial repression

Even over the longer term, the legacy of the pandemic will mean that central banks have a strong incentive to keep interest rates very low. Public debt has risen to record-high levels as a result of the crisis and governments will be reluctant to pursue austerity to reduce the debt load. The maintenance of ultra-low interest rates to ease the burden of servicing the debt while economies grow their way out of it is a much more palatable option.

Of course, while governments in some emerging economies might instruct their central banks to repress interest rates, those in advanced economies are typically independent. But the line between monetary policy and fiscal policy has already blurred significantly in recent years. For example, the Bank of England has openly said that recent asset purchases helped government bond markets to function in the face of large amounts of issuance. Even viewed through the narrow lens of inflation targeting, higher interest rates might imply a fall in inflation to below target if they necessitated a return to austerity. (See our latest Global Economics Focus.)

In all, then, our hopes about a vaccine have not led us to change our view that monetary policy will remain very loose for several years to come. Accordingly, the returns from government bonds are likely to be mediocre for years, while riskier assets are set to outperform.


Monetary Policy Developments

Review of recent policy rate changes

The global easing cycle has more or less come to a halt over recent months. Of the twenty central banks covered in this document, three have altered their key interest rates since the beginning of September. (See Chart 2.) The central banks of Mexico and Australia cut their policy rates by 25bps and 15bps in September and November, respectively. Meanwhile, Turkey’s central bank hiked its 1-week repo rate in September and November, by a combined 675bps, in order to prop up the lira.

Chart 2: Changes in Benchmark Rates

Source: Bloomberg, Capital Economics

Balance sheet policy of DM central banks

The balance sheets of the Bank of Japan and European Central Bank (ECB) have continued a steady expansion in recent months, in contrast to those of the Bank of England (BoE) and the US Fed. (See Chart 3.) Growth in the BoE’s balance sheet has tailed off in this time. Meanwhile, the Fed’s balance sheet has flat-lined in recent months. But this is because its monthly asset purchases have been offset by the expiry of its earlier temporary repo market operations and dollar swap lines with other central banks. Now that these emergency programmes have run their course, the balance sheet should rise in line with its asset purchases in future months.

Looking to the future, we expect that most major advanced economy central banks will continue to expand their balance sheets. In some cases, more support should be announced before the end of the year. And we expect further loosening next year too.

In the US, we have already mentioned that the Treasury’s decision not to extend the Fed’s 13(3) emergency lending facilities beyond 2020 might encourage it to utilise other tools. Most likely, this

Chart 3: Central Bank Balance Sheets as % of GDP

Sources: Refinitiv, Capital Economics

will involve an increase in and/or re-focusing of asset purchases towards longer-dated Treasuries.

Alongside an announcement of additional TLTRO operations with even more generous terms, we think that the ECB will raise the ceiling of purchases made under the Pandemic Emergency Purchase Programme (PEPP) and extend purchases until mid-2022. Meanwhile, we have also pencilled in a SEK 200bn expansion of asset purchases by the Riksbank and see the bank pushing back the expiry of its asset purchase programme back to mid-2022 too.

In the UK, the BoE recently delivered more QE as we had previously forecast. And we expect that there is more to come in 2021, with the BoE expanding QE by at least another £100bn in 2021.

The Bank of Canada is the only one scaling down the size of its programme, cutting asset purchases from a minimum of $5bn to $4bn per week. However, its re-focus of purchases towards longer-term bonds should mean that QE there is still just as stimulative.

Interest rate cuts the exception not the norm

Interest rates in most advanced economies are at or around the lower bound, so we do not expect many policy rate changes as monetary policy is loosened through other channels. (See Table 1.) While there has been talk by some BoE policymakers of cutting into negative territory, we think the MPC will stick with more QE and shun negative interest rates for the next 6-12 months. The exception to this theme is in Sweden, where we expect the Riksbank to reimpose negative interest rates by cutting the repo rate by 25bp in 2021 against a backdrop of persistently weak price pressures.

Table 1: Summary of CE Forecasts for Policy Rate
Net Changes by the End of 2021

Policy Direction

Economies

Easing

Sweden, Denmark, New Zealand, India, Russia, Mexico

No Change

US, UK, Euro-zone, Japan, Canada, Australia, Switzerland, Norway, Brazil, South Korea, Turkey, Poland, South Africa

Tightening

China

Source: Capital Economics

China hiking alone

While most EMs will continue to ease policy, there are a couple of exceptions in China and Turkey.

China’s economy has recovered quickly from the COVID downturn and growth has accelerated to a three-year high. We expect the People’s Bank of China (PBOC) to begin to tighten monetary policy, but only by a modest amount. Economic activity has been propped up by fiscal support which will fade next year and the PBOC will want to avoid adding too much fuel to the renminbi’s recent rally.

Meanwhile, Turkey’s 475bp hike in its one-week repo rate and pledge to provide all funding through this facility, in addition to a shake-up in its economic management team, appears to have convinced investors that a positive shift in policymaking is taking place. The lira appreciated on the back of this, and we expect the central bank to keep its policy rate on hold while the lira’s rally has a bit further to run.

In other EMs, we expect policy to continue to be loosened in 2021. In those economies which entered the crisis with higher interest rates, such as Russia, Mexico, and India, we expect further policy rate cuts. But in Poland and Korea, where nominal rates are close to the lower bound, we expect support to come through an expansion of existing asset purchase programmes.

Table 2: Central Bank Policy Rates

Country

Policy rate

Latest

Last Change

Next Change

(CE Forecast)

End-2020

End-2021

End-2022

Major Advanced Economies

US

Fed funds target

0.00-0.25

Down 150bp (Mar. 2020)

None on horizon

0.00-0.25

0.00-0.25

0.00-0.25

Euro-zone

Deposit rate

-0.50

Down 10bp (Sep. 2019)

None on horizon

-0.50

-0.50

-0.50

Japan

Interest on excess reserves

-0.10

Down 10bp (Jan. 2016)

None on horizon

-0.10

-0.10

-0.10

UK

Bank Rate

0.10

Down 65bp (Mar. 2020)

None on horizon

0.10

0.10

0.10

Other Advanced Economies

Canada

Overnight target rate

0.25

Down 150bp (Mar. 2020)

None on horizon

0.25

0.25

0.25

Australia

Cash rate

0.10

Down 15bp (Nov. 2020)

None on horizon

0.10

0.10

0.10

Switzerland

Sight deposit rate

-0.75

Down 50bp (Jan. 2015)

None on horizon

-0.75

-0.75

-0.75

Sweden

Repo rate

0.00

Up 25bp (Dec. 2019)

Down 25bp (Q3 2021)

0.00

-0.25

-0.25

Denmark

Deposit rate

-0.60

Up 15bp (Mar. 2020)

Down 15bp (Q1 2021)

-0.60

-0.75

-0.75

Norway

Sight deposit rate

0.00

Down 25bp (Apr. 2020)

None on horizon

0.00

0.00

0.00

New Zealand

Cash rate

0.25

Down 75bp (Mar. 2020)

Down by 50bp (Q2 2021)

0.25

-0.25

-0.25

Major Emerging Economies

China

7-day reverse repo rate

2.20

Down 20bp (Mar. 2020)

Up 10bp (Q1 2021)

2.20

2.50

2.50

India

Repo rate

4.00

Down 75bp (Mar. 2020)

Down 25bp (Q1 2021)

4.00

3.50

3.50

Brazil

Selic rate

2.00

Down 25bp (Aug. 2020)

Up 25bp (H1 2022)

2.00

2.00

3.00

Russia

1-week repo rate

4.25

Down 25bp (Jul. 2020)

Down 25bp (Feb. 2021)

4.25

3.50

3.50

Mexico

Overnight target rate

4.25

Down 25bp (Sep. 2020)

Down 25bp (Q1 2021)

4.25

4.00

4.00

South Korea

Base rate

0.50

Down 25bp (May 2020)

None on horizon

0.50

0.50

0.50

Turkey

1-week repo rate

15.00

Up 475bp (Nov. 2020)

Down 50bp (H1 2022)

15.00

15.00

12.50

Poland

Reference rate

0.10

Down 40bp (May. 2020)

None on horizon

0.10

0.10

0.10

South Africa

Repo rate

3.50

Down 25bp (Jul. 2020)

None on horizon

3.50

3.50

3.50

Sources: Bloomberg, Capital Economics.

Table 3: Quantitative Easing & Other Unconventional Policies

Central bank

Planned Asset Purchases & Lending Facilities

CE Forecast of Future Changes

Federal Reserve Bank

The Fed has pledged to continue large-scale asset purchases at least at the current pace – equating to about $120bn per month. The Treasury has decided not to extend most the Fed’s 13(3) lending facilities lending facilities beyond 2020.

We don’t expect the Fed to do anything more than they have announced. But on the back of the Treasury not extending the Fed’s 13(3) lending facilities, there is a slightly higher chance of the Fed increasing its Treasury purchases and/or re-focusing them towards the long end of the curve.

European Central Bank

Net purchases under the Pandemic Emergency Purchase Programme (PEPP) will continue until at least the end of June 2021 and will total €1.35trn. Targeted longer-term refinancing operations (TLTROs) to continue.

We suspect that policymakers will announce a new ceiling for PEPP purchases, perhaps of €2trn, and an extension of net purchases until mid-2022. The ECB is also likely to announce additional TLTRO operations, as well as making the terms more generous.

Bank of Japan

The Bank of Japan’s “Special Program” includes purchases of commercial paper and corporate bonds as well as loans to banks. The Bank has raised the ceiling of the lending facility to ¥110tn in recent months and committed to lifting its holdings of commercial paper and corporate bonds by ¥7.5tn by March. It has also committed to ¥12tn of annual ETF purchases, but hasn’t met this target since April.

Commercial paper and corporate bonds yields are close to zero and stock prices are high, so we don’t expect the Bank to lift its purchases of securities any higher. And with bank lending now slowing, it seems unlikely to raise the ¥110tn ceiling on its coronavirus lending facility either.

Bank of England

The Bank of England raised the total stock of QE announced since March to £450bn by expanding the bond-buying programme by £150bn in November. The MPC does not expect to complete the £150bn until around the end of 2021.

We think that the MPC will shun negative interest rates for the next 6-12 months and instead expand QE by at least another £100bn in 2021, far more than the consensus expects.

Bank of Canada

The Bank of Canada recently announced that it was cutting the pace of its government debt purchases from a minimum of $5bn per week to a minimum of $4bn per week, despite its balance sheet contracting lately. These purchases should provide just as much stimulus as before because the Bank will now focus them further out on the yield curve.

The Bank’s pledge that its asset purchases will continue “until the recovery is well underway” leaves us to think it will officially start tapering them from mid-2021. Before then, we expect it to explicitly tell us that it will be re-investing maturing bonds to prevent its holdings contracting over that period.

Swiss National Bank

The SNB has recommended cutting the countercyclical capital buffer to zero and offered unlimited liquidity to banks. It has intervened heavily in the FX market to counter upward pressure on the franc related to risk aversion.

We expect FX intervention to remain the Bank’s weapon of choice to fend off bouts of upward pressure on the currency.

Riksbank

The Riksbank’s envelope of asset purchases extends to SEK 500bn, lasting until mid-2021. The Riksbank announced that it would start buying corporate bonds from mid-September as part of its asset purchase programme.

The Riksbank is likely to expand and extend its asset purchase programme again. We have pencilled in a SEK 200bn increase, to SEK 700bn, and see the end-date being pushed back by a year to mid-2022.

Sources: Central banks, Capital Economics.

Table 4: Calendar of Policy Decisions

Date

Economy

Policy Instrument

Prior

Survey

CE Forecast

26th November

South Korea

Base Rate

0.50

0.50

Sweden

Deposit Rate

0.00

0.00

1st December

Australia

Cash Rate

0.10

0.10

2nd December

Poland

Reference Rate

0.10

0.10

4th December

India

Reverse Repo Rate

4.00

4.00

9th December

Brazil

Selic Target Rate

2.00

2.00

Canada

Overnight Target Rate

0.25

0.25

10th December

Euro-zone

ECB Deposit Rate

-0.50

-0.50

16th December

United States

Fed Funds Target Range

0.00-0.25

0.00-0.25

17th December

Switzerland

Policy Rate

-0.75

-0.75

Norway

Policy Rate

0.00

0.00

United Kingdom

Bank Rate

0.10

0.10

Mexico

Overnight Lending Rate

4.25

4.25

18th December

Russia

1-week repo rate

4.25

4.25

Japan

Interest on excess reserves

-0.10

-0.10

20th December

China

7-day Repo Rate

2.20

2.20

24th December

Turkey

7-Day Repo Rate

15.00

15.00

8th January

Poland

Reference rate

0.10

15th January

South Korea

Base rate

0.10

18th January

Mexico

Overnight Lending Rate

4.25

20th January

Canada

Overnight Target Rate

0.25

21st January

Norway

Policy Rate

0.00

Turkey

7-Day Repo Rate

15.00

Euro-zone

Deposit Rate

-0.50

Japan

Interest on excess reserves

-0.10

27th January

United States

Fed Funds Target Range

0.00-0.25

29th January

Australia

Cash Rate

0.10

4th February

United Kingdom

Bank Rate

0.10

5th February

India

Reverse Repo Rate

3.75

10th February

Sweden

Deposit Rate

0.00

12th February

Russia

1-week repo rate

4.00

Sources: Bloomberg, Capital Economics


Jennifer McKeown, Head of Global Economic Service, jennifer.mckeown@capitaleconomics.com
Kieran Tompkins, Assistant Economist, kieran.tompkins@capitaleconomics.com