Are we running out of policy ammo?

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As commentators ponder what options are left to fight the economic fall-out from Covid-19, managers and experts from BNY Mellon Investment Management offer their views on the future direction of fiscal and monetary stimulus.

At times of great economic stress, wartime metaphors tend to come thick and fast. So it is with Covid-19. In recent months, world leaders have variously talked about fighting an invisible enemy, declared war on the virus or invoked the ‘Blitz spirit’.

Economists have succumbed to the temptation too. For the International Monetary Fund (IMF), the pandemic “feels like a war”¹ with the associated need to put the economy on a war footing. The baseline, the IMF says, is to “guarantee the functioning of essential sectors… provide enough resources for people hit by the crisis and… prevent excessive economic disruption.”

At other times, the comparisons have been with the Great Depression. Are we entering a period of latter-day Hoovervilles, soup kitchens and New Deal-era public works with nothing to fear except fear itself? With about 13% of the US labour force unemployed – and comparable figures elsewhere in the world – the Great Depression analogy certainly seems appropriate.

Hovering around these two metaphors for our time is the unspoken question: How much ammunition do policymakers have left to fight the economic contagion of Covid-19? Are we down to our last round and a final stand or is there more central banks and governments can do?

For Newton head of fixed income Paul Brain, the Covid-19 war-time analogy makes sense and he references the post-World War II Marshall Plan² as an example of how policy intervention may help us avoid looming disaster. 

Brain notes the response from the authorities thus far has settled into three broad tranches: central banks slashing rates and re-starting quantitative easing (QE), emergency funding (including wage support) and long-term plans to stimulate investment.

The first response provides liquidity and stops the health crisis from becoming a financial one, the second partially recoups the drop in GDP while the third helps the economy recover and adjust to a new way of doing business,” he says.

Ultimately, according to Brain, the key question is not whether policy tools exist but whether the authorities have the ability or will to implement them. For the first phase, he says, central banks have already exhausted interest rate headroom and are now solely reliant on QE. The second phase – emergency funding and wage support – has a fourth-quarter expiry date in many countries.

Looking further forward, the success of the third tranche depends on whether investment programmes lead to growth or become white elephants. “Creating debt to invest is only sustainable if there’s a return on the investment, most obviously in the form of tax receipts,” notes Brain. “Unfortunately, governments don’t have a particularly good track record in this area.

QE as the new normal

For Mellon fund manager Rowena Geraghty, one of the interesting things about the response to Covid-19 is how policies once considered unorthodox have become the new normal – with central banks around the world continuing to push those boundaries.

The European Central Bank, for instance, has provided monetary stimulus since the onset of the pandemic – recently expanding its emergency QE programme and beating expectations in both its magnitude and duration,” she explains. “It’s also maintained its dovish language regarding future increases in QE as well as continuing to provide inexpensive liquidity operations for banks.

That means seeking assistance from other authorities – such as the European Commission – and progress towards a Europe-wide €500bn Recovery Fund as proposed by German Chancellor Angela Merkel,” she adds.

Constraints and opportunities

Sebastian Vismara, financial economist with the BNY Mellon Global Economics and Investment Analysis Group, makes a similar point, noting how the crisis is forcing policymakers to become more proactive.

Here, he says, one option might be to introduce new tools to limit the increase in nominal rates and raise inflation expectations, leading to a decline in real interest rates. In the US, this could include some version of yield curve control and a change in monetary policy strategy to accommodate higher inflation and make up past shortfalls of inflation from target.

Given the more severe lack of policy space, the Bank of Japan (BoJ) is the central bank more likely to be experimenting with novel policy tools,” he adds.

The view from Japan

Indeed, with its past experience of dealing with a prolonged downturn, it’s little wonder that many commentators have turned to Japan to try to understand where we go from here.

Miyuki Kashima, manager of the BNY Mellon Japanese Smaller Companies strategy, notes the country’s relative success in dealing with the Covid-19 crisis is partly down to the combined firepower of its monetary and fiscal response. Taken together, she says, they recall the early days of Abenomics³ . “It’s a high octane version of that set of policies but far more punchy,” she concludes. “The sums being made available are huge: it’s fiscal stimulus on steroids.

¹ International Monetary Fund: ‘Economic Policies for the COVID-19 War’, 1 April 2020.
² The Marshall Plan was an American initiative to rebuild a Europe devastated by World War Two. In four years it transferred over US$12bn (at 1948 prices) in economic aid to the war-ravaged continent.
³Abenomics: A coordinated fiscal and monetary stimulus package introduced by Prime Minister Shinzo Abe in 2013 credited with lifting the Japanese economy out of deflation.

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