Global Weekly Commentary: Policy revolution: What’s next?
Key points
A needed revolution
Macroeconomic policy has undergone a necessary revolution in just three months, but this is a slippery slope without proper guardrails.
Key to policy response
The key to the policy response has shifted to ensuring successful execution and avoiding policy fatigue before the shock passes.
Fed watch
This week’s Federal Reserve policy meeting will be in focus as markets watch for the Fed’s take on the economic rebound.
Macroeconomic policy has gone through a needed revolution to cushion the coronavirus shock. It essentially aims to “go direct” and is blurring fiscal and monetary policies. Yet this policy shift has opened the door to unprecedented government intervention in markets and companies, and we see it as a slippery slope - unless it comes with proper guardrails and a clear exit strategy.
Chart of the week
Estimated economic impact vs. policy measures, 2020 to date
Sources: BlackRock Investment Institute, with data from the Federal Reserve, European Central Bank, Bank of Japan, Bank of England, and Haver Analytics, June 2020. Notes: We use estimated targets for the total size of the U.S. and euro area corporate purchases and lending schemes for 2020. For the euro area we include TLTRO funding, and for the UK we include central bank support for the TFS bank lending scheme. The euro area numbers are averages of the four largest economies in the bloc, Germany, France, Italy and Spain.
The scale and speed of the policy response has been greater than at any moment in peacetime history, fundamentally transforming the core tenets of global policy frameworks and financial markets. We view the economic impact and policy response as two key signposts for gauging the virus shock, and compare our assessment of the lost national income across major economies with policy measures announced to date. The orange bars show the full-year hit to GDP from our sector-level bottom-up analysis, including the initial impact on the most affected sectors (such as travel and leisure) and the broader impact on the whole economy due to spillover effects (light orange). The fiscal response more than covers the initial impact in the U.S. Once we factor in the spillover to the full economy, the fiscal policy response (dark yellow) globally falls short. Yet the situation improves when monetary policies (light yellow) are accounted for. This is especially striking in the U.S., as the chart shows.
Major economies may still struggle to entirely bridge the gap left by the plunge in demand, income and cash flow, despite the unprecedented policy measures, in our view. We see a risk of policy fatigue leading to an exit or a retrenchment too soon, especially in the U.S. The U.S. labor market unexpectedly improved in May, showing signs that policy interventions were cushioning the blow from the shock – and highlighting the risk that policymakers may give up on relief measures sooner than necessary.
The uncharted territory that policymakers have entered makes policy execution particularly important. The new policies explicitly attempt to “go direct” – bypassing financial sector transmission and delivering liquidity to individuals and businesses. Another aspect of this policy revolution is the explicit blurring of fiscal and monetary policies, including central banks absorbing new government debt to maintain low bond yields. In addition, some government support comes with strings attached, including conditions around dividend payouts and share buybacks.
We wrote about the necessity for monetary and fiscal coordination to deal with the next downturn last August. Effective coordination would reduce lost output in a major shock, and could lessen other risks, such as rising inequality, that were seen as arising from the unbalanced policy response to the financial crisis. We warned it needed proper guardrails and a clear exit strategy to mitigate a risk of uncontrolled deficit spending with commensurate monetary expansion and, ultimately, inflation. One approach we laid out is a Standing Emergency Financing Facility (SEFF), a framework in which the exit from the joint monetary-fiscal policy effort is explicitly determined by the inflation outlook. To be credible, this exit decision must be independently controlled by the central bank. And even a well-designed monetary strategy may not prevent a change toward a higher inflation regime in the medium term because of deglobalization and re-regulation trends.
The bottom line: The policy revolution is a near-term positive for markets but, in the absence of guardrails, might not be in the medium term. One key investment implication is the reduced ballast properties of nominal government bonds over a strategic horizon, as interest rates are near or at their effective lower bounds and we see greater inflation risks in coming years. We think increased strategic allocations to inflation-linked bonds are sensible amid this shifting balance of risk.
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