Covid-19: Central Banks Fail to Bring Comfort

16 March 2020

Global central banks have announced additional emergency stimulus measures. In particular, the US Federal Reserve reduced its policy rate by 100 basis point, which now stands near zero. In addition, the Fed will resume aggressively its quantitative easing program. During the Global Financial Crisis global markets were reassured by such assertive policy actions. No longer. As occurred following last week’s 50bp Fed rate cut, investors continued to run for cover, despite the provision of additional liquidity.

The Chart above makes what may by now be an obvious point. At the outbreak of the GFC, central banks had ample scope to ease monetary conditions. Currently, however, G3 policy rates are either zero or negative, and the same is true in Sweden and Switzerland. Even in some Asian nations, Korea and Thailand in particular, interest rates are already low as a result of ongoing deflationary pressures.

The main purpose of the emergency monetary measures is to ensure the proper functioning of the financial system, rather than directly stimulating demand in the economy. Fortunately, the financial system is much better placed to perform its role, unlike during the GFC (when these institutions were at the heart of the problem). Despite the more limited room to maneuver, G3 central banks will continue to make use non-conventional tools to provide liquidity to the financial system. And, we should expect considerable interest rate reductions in the Emerging Markets, especially Mexico, Russia, India, Turkey, and others.

Fiscal Policy Must Lead the Way

With the scope for monetary action becoming more limited, can budgetary policy play a larger role. In this crisis, fiscal policymakers will need to juggle several priorities. The chief goal is to ensure resources are available to the health care system. Secondly, worker support will also be required. Sick pay should be available for those needing to recover or self-isolate.

Meanwhile, policy should seek to ensure that what hopefully will be a temporary shock does not inflict permanent damage to the economy. Financial support for viable firms, especially in hard-hit sectors, e.g. aerospace, travel, and hospitality, will be needed.

In addition to measures on the supply side, policymakers must consider how to boost demand: for example, unemployment compensation or tax cuts for households.

Again, however, the legacy of the GFC limits to scope for aggressive action. The Chart above illustates that public sector debt levels are higher than pre-GFC levels in all areas. Moreover, government debt continues to rise in Japan, USA, Italy, and France.

However, several countries have considerable scope for stimulate fiscal programs. The Chart above shows that the austerity measures of the past decade have greatly improved the budgetary position in key European countries. Likewise, the earlier Chart illustrates that government debt is low and declining in Germany, Netherlands, Switzerland, Scandinavia, and central Europe. The UK has recently announced a multi-year boost to public sector spending. It is now time for German to lead the way in the European Union and beyond!

I also anticipate additional fiscal stimulus in many emerging market nations, especially in much of Asia. The two Charts indicate that public sector finances are healthy in Russia, Korea, Thailand, Indonesia, Mexico, and central Europe. Turkey and India could provide more limited support. South Africa and Brazil are still more strapped for cash. China pledges to do whatever it takes. While this is likely, IMF fiscal indicators suggest China may have less room to act than expected.

Implications

  • The legacy of the Global Financial Crisis limits governments’ ability to stimulate macroeconomic policy. As a result, financial markets are not reassured, even when approapriate actions are taken.
  • Even though G3 interest rates are at zero, additional non-conventional tools will be deployed to provide liquidity to the financial system.
  • Many EM central banks have additional ability to lower interest rates.
  • Fiscal policy must play a large role. The priority is to ensure health care resources are availiable, to provide supply-side economic support, and to boost demand.
  • Germany must lead Europe’s fiscal stimulus.
  • Despite high levels of debt, fiscal authourities (especially in the USA) will take advantage of low interest rates to boost spending during this crisis. Dithering in the US Congress and Treasury must end!