By Robin Marshall, director, fixed income research
The Bank of England and Fed have scope to double QE programs…
Central banks have welcomed the news about a recent COVID-19 vaccine breakthrough. However, implementation risks remain on vaccines, and a more flexible policy armory may still be required because monetary policy initiatives, since the COVID-19 crisis, have closely followed the GFC playbook. Policymakers have eschewed direct, money-financed, fiscal stimulus, or "helicopter money" (HM), involving direct purchase of central government debt. Instead, central banks have either expanded purchases of government and corporate bonds in the secondary market, or broadened corporate loan programs. Chart 1 shows both the Fed and Bank of England still have modest balance sheets, as a percentage of GDP, compared to the ECB and BoJ.
G7 fiscal stimulus appears substantial, but these deficits are magnified as a percentage of GDP by the collapse in GDP, which the IMF forecasts to be about three times the scale of the GFC economic contraction, at -4.9% in 2020, as Chart 2 shows.
…but using GFC playbook in a liquidity trap may have little impact, as BoJ found
Even if the Fed and BoE switched to bigger balance sheet expansions, the risk remains that the GFC playbook may not deliver the required increase in aggregate demand and economic recovery. Japan’s experience suggests once deflationary expectations are entrenched, a liquidity trap can soon follow. Hence, despite negative interest rates and the BoJ's balance sheet reaching over 140% of GDP (shown in Chart 1), neither inflation nor inflation expectations have recovered to near the 2% target, as the 7-10yr inflation breakeven levels show in Chart 3.
Evidence on the efficacy of negative interest rates is also mixed
Nor is it easy to see why negative nominal rates would deliver a sustained recovery, when the current deflation is not caused by high nominal interest rates, but a public health emergency. In theory, negative deposit rates reduce the incentive to hold cash in bank accounts, and should drive increased spending, but they may squeeze banks and financial systems, and returns for pension schemes.
Furthermore, if the demand for savings is exceptionally strong, making policy rates negative is unlikely to boost spending more than marginally. They may also hit confidence, and encourage wholesale withdrawals of deposits from banking systems, like Northern Rock in 2007.
Finally, by holding policy rates below the true marginal cost of capital, negative rates increase the risk of “zombifying economies” by supporting loss-making companies, and subordinating monetary policy to the task of propping up financial markets. It then becomes difficult to normalize interest rates without increasing deflation risks, so once policy rates become negative, they may remain negative for an extended period (i.e., the ECB & BoJ).
COVID-19-bond financed stimulus, is unlimited in size and not temporary
This suggests permanent support for aggregate demand may be needed from direct, money-financed, fiscal stimulus (HM). Since this is potentially unlimited in size, and therefore able to secure recovery, it has been argued that avoiding this form of stimulus is a clear policy choice . It could be supported by strong governance from central banks on the use of the central government's account at the central bank, and subject to inflation targets not being breached .
…it could be permanent, reduce debt costs and the threat of future austerity
Such fiscal stimulus would be distinct from the current stimulus and QE, which is not designed as a permanent increase in money supply, or in debt issuance, but carries the deflationary threat of future austerity (Ricardian equivalence). It could be achieved by issuing perpetual COVID-19 bonds, carrying a zero, or near zero coupon, to be purchased by the national central bank. This would be quite different from the UK’s War Loan, since War Loan raised UK finance from the private sector for the first world war, and was not money-financed by the BoE. It also carried what now seems a high coupon (of 3.5% from 1932-2015). The coupon is also irrelevant anyway if central government is effectively paying the coupon to itself, via the central bank. Given that a 50-year gilt currently yields about 0.8%, the interest savings on a £300 billion perpetual would be about £2.4 billion per annum with a zero coupon, with those interest savings boosted further by the positive multiplier effects on GDP growth, employment and tax revenues. Ironically, the Eurozone, which was the last major economy to adopt QE programs, has come closest to going down this route, by agreeing the issue of a mutualized COVID-19 bond, though there is no proposal as yet, that the ECB finance it by printing money.
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 See “Ultra-low or negative interest rates: what they mean for financial stability and growth,” Herve Hannoun, BIS, April 2015. “Wicksell’s natural rate”, R. Anderson, St Louis Fed Short Essays, 2005.
 “The simple analytics of helicopter money, Why it works, Always,” W. Buiter, Kiel Institute Discussion Paper, No 2014-24.
 See FTSE Russell blog, April 2020.
 War Loan was issued in 1917, to help pay for the UK’s WW1 expenditures, and redeemed in 2015.
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