William De Vijlder

Wall Street has entered a bear market, having declined more than 20% from its high. Equity markets globally have seen huge declines this week and corporate bond spreads have widened significantly.Despite the positive news from China, the combination of an uninterrupted international propagation of the coronavirus has dealt a blow to expectations about the growth outlook for the next several months. The oil shock has made matters worse.Central banks have reacted. After the Fed rate cut last week, the Bank of England cut rates as well and the ECB also took several measures to support activity.The instrument of choice at the present juncture is fiscal stimulus of a sufficient size. Both in the US and the eurozone, we are still waiting for this impulse.

The Federal Reserve created a surprise this week by, quite unusually, going for an inter-meeting cut of the federal funds rate of 50 basis points. At first glance, the very nature of an epidemic makes monetary policy ill-equipped to address the consequences. The drop in demand and the disruption of supply are not related to the level of interest rates. Nevertheless, monetary policy has an important role to play in the current environment by seeking to avoid a deterioration of the financial and monetary conditions. This is a defensive move, the alternative being to run the risk that the tightening of these conditions acts as an additional brake on activity. It seems this has played a role in the decision of the FOMC and it now puts the onus on the ECB to act at its meeting next week.

As part of the Federal Reserve’s strategy review, the introduction of a target range for inflation is being discussed. Such a range could provide flexibility in the conduct of monetary policy. It could also take into account past shortfalls in inflation. Introducing a range when inflation is below target runs the risk of being perceived as not being bothered by the inflation shortfall. This would call for an asymmetric range but this increases the risk of market turbulence when a tightening cycle starts.

The ECB remains cautious in its assessment of the economic situation characterised by risks still tilted to the downside, although less than before thanks to the US-China trade deal
The message is slightly better on underlying inflation where some signs of a moderate increase are noted
Between now and year-end, the strategy review, which has now been launched, will grab a lot of attention, with markets wondering how it could influence monetary policy
The review is also important from the perspective of climate change: will monetary policy operations take it on board as a risk factor or will ambition even be higher?

Danish monetary policy is closely linked to ECB policy so the recent statement of Denmark’s central bank governor that he expects interest rates to remain around current negative levels in the next five to ten years is not without importance for the Eurozone. Forward guidance by ECB implies that policy will only be adjusted when justified by economic conditions. The inability to be clearer in terms of time frame illustrates the complexities of inflation dynamics. Past wage increases will gradually filter through in a pick-up in inflation although low inflation, well-anchored inflation expectations and intense competition in certain sectors may very well moderate this transmission. It thus seems clear that the current policy will remain in place for a considerable time. How long ’considerable’ turns out to be will depend on the data. The eurozone clearly needs more growth.

The Japanese government bond yield curve has been flattening in recent months, with very long maturities coming dangerously close to 0%. This is creating concerns amongst institutional investors with long-dated liabilities (insurance companies, pension funds). Bank of Japan Governor Kuroda has argued that an excessive decline in super-long-term interest rates could negatively impact economic activity
This has raised expectations that the central bank could shift to a policy of controlling the slope as well as the level of the yield curve. This could influence bond yields abroad. In the eurozone it would intensify the debate about the impact of ECB policy on pension funds and insurers.

Interest rates are very low and often negative in many countries of the eurozone. This raises the concern that eventually we would be confronted with the paradox of thrift whereby the households’ saving rate increases. This would imply that monetary policy becomes powerless to boost growth.

Germany is probably in a technical recession and recent data do not point to any improvement in the near term, quite to the contrary. Given the country’s considerable budget surplus, German business leaders are calling for fiscal stimulus. This echoes Mario Draghi’s plea in favour of budgetary expansion in countries with fiscal space. Simulations show that spillover effects to other eurozone countries would be small. Moreover, the implementation of a fiscal package requires long preparation and may be hampered by labour shortages.

The Federal Reserve and the ECB are in very different positions: the former has more room to ease policy and it is also closer to its policy targets. The ECB has limited remaining policy leeway but is confronted with an inflation shortfall versus its aim and a risk that this gap would increase, rather than narrow. These differences have led to diverging approaches in the conduct of and communication about monetary policy. The Fed is data-dependent and, except for the projections of the FOMC members, offers no guidance. The ECB is agnostic about the data and builds its communication around state-dependent forward guidance: policy tightening will be solely conditioned by meeting its target. The ECB stance reduces the sensitivity of financial markets to data surprises whereas the Fed stance increases it. This implies a risk of higher volatility in the US but also, via international spillovers, abroad.

Market expectations were elevated but the Governing Council did not disappoint. The comprehensive nature of the package, with the introduction of state-dependent forward guidance, take away the need to envisage additional measures in the foreseeable future. ECB watching has been narrowed to monitoring the gap between inflation and the ECB target. Given certain negative side effects of the current monetary mix, which are acknowledged by the Governing Council, fiscal policy, where leeway is available, is now requested to step up to the plate, so as to foster growth and speed up convergence of inflation to target. The policy baton has been passed

The Governing Council has tasked Eurosystem committees to examine its monetary policy options. Given the insistence on its determination to act, Thursday’s meeting outcome was basically a pre-announcement of easing in September. Being aware of the importance of maintaining the ECB’s inflation targeting credibility, Mario Draghi was very explicit in expressing his dissatisfaction with current inflation and its outlook, adding that a highly accomodative monetary policy is here to stay for a long period of time

Fed Chairman Powell, in his address to Congress this week, has confirmed that easing is coming. In June, ECB President Draghi provided similar hints. This comes on the back of growing concerns regarding global growth and ultimately facing too low a level of inflation. Risks may be mounting, but, on the other hand, the unemployment rate is close to the natural rate. There are reasons to assume that monetary easing under full employment would be less effective than when the economy is marred in recession. Monetary easing could also raise concerns about financial stability, which, if unaddressed, could weigh on the ability of monetary policy to successfully boost inflation.

A high level of uncertainty can act as a drag on growth. Whether monetary easing will succeed in boosting growth will depend on the nature of uncertainty. Endogenous uncertainty follows from the normal development of the business cycle and rate cuts should succeed in reducing this uncertainty by boosting confidence of economic agents. Exogenous uncertainty is not driven by the business cycle but is triggered by other factors, such as, in the current environment, ongoing trade disputes. In this case, monetary policy effectiveness suffers and, despite rate cuts, the growth slowdown should continue until its root cause (exogenous uncertainty) is addressed.

The Fed has turned the corner and is now looking towards moving into easing mode. Low inflation makes this possible, slowing growth and significant external headwinds make it a necessity. However, the track record of successful soft landings is poor. In the current environment, the challenge is considerable given already low rates in a very mature expansion. The biggest issue however is uncertainty with respect to trade.

ECB President Mario Draghi, speaking at Sintra, has raised expectations of renewed policy easing. The message from the FOMC meeting is that rate cuts are coming. This policy synchronisation reflects shared issues (inflation too low versus target) and shared concerns, the major being rising uncertainty. Should this continue, the effectiveness of monetary accomodation will suffer.

The relationships between government debt, economic growth and interest rates are complex and varied. In general, a recession causes an increase in government debt and a decline in government borrowing costs. A prolonged period of monetary accommodation during a cyclical upswing can cause the average nominal interest rate on government debt to drop below the rate of nominal GDP growth. Depending on the level of the primary balance, such a situation can, under certain conditions, create leeway for fiscal expansion in order to support growth.

The pass-through of wage growth to prices is stronger and faster when inflation is higher to start with. The low inflation in the Eurozone has slowed down the transmission. The considerable growth slowdown, on the back of adverse foreign demand and uncertainty shocks, impairs this process even more. This raises pressure on the ECB to take action in order to dislodge core inflation, which remains stuck well below its objective.

President Trump has argued that the US economy would get a boost if the Federal Reserve were to cut rates. The minutes of the FOMC show the members are confident about the growth outlook. The outlook for inflation, against a background of global uncertainties, allows them to be patient in terms of policy. The IMF in its latest Global Financial Stability Report expresses concern about how high debt levels weigh on the resilience when faced with significantly slower growth or higher borrowing costs. This implies that Fed policy will not only be confidently patient but also patiently vigilant.