Time for a macroeconomic policy rethink?

Robert Subbaraman
One of the lasting policy impacts of the crisis is likely to be the blurring of lines between monetary and fiscal policies, with a Keynesian-style fiscal expansion being employed alongside unconventional monetary policy. More radical policies could be in store
Managing Director, Head of Global Macro Research and Co-Head of GM Research at Nomura

One of the lasting policy impacts of the crisis is likely to be the blurring of lines between monetary and fiscal policies, with a Keynesian-style fiscal expansion being employed alongside unconventional monetary policy. More radical policies could be in store

Even before COVID-19, central banks had undershot their inflation targets for a very long time. Several prominent economists such as Lawrence Summers, Olivier Blanchard, Stanley Fischer, Paul Krugman and Kenneth Rogoff had called for a fundamental rethink of the appropriate macroeconomic policy framework to tackle secular stagnation—high private saving in excess of deficient private investment—and the long-run decline in the natural real rate of interest to near zero.

Most advocated a greater role for Keynesian-style expansionary fiscal policies alongside a new monetary policy regime.

In a nutshell, before COVID-19, the policy prescription to overcome secular stagnation was moving towards a combination of 1) tolerating large budget deficits; 2) accepting unconventional monetary policies as the new normal; and 3) implementing reforms that promote private investment and reduce saving.

Enter COVID-19

The COVID-19 crisis has caused the swiftest, deepest and broadest global recession since the Great Depression.

The size of the global monetary and fiscal policy response has been unprecedented, yet it has been more a buffer than a stimulus for economies that continue to be ravaged by the pandemic.

In the US, for example, only 9 million of the 22 million workers who lost their jobs in March and April have been re-employed. The US corporate sector has experienced about $800 billion in downgrades of investment-grade debt, a faster pace than during the initial months of the Global Financial Crisis (GFC), even with the extraordinary policy support.

The pandemic is likely to turn out most severe in emerging markets, where poorer countries face an even starker trade-off between saving lives and preserving livelihoods.

The inflation targets of central banks were elusive even before COVID-19. Now, meeting their dual mandates of 2% inflation and full employment have been dealt a huge blow. Fed Governor Lael Brainard described the grave challenges in a speech on 14 July: “A thick fog of uncertainty still surrounds us, and downside risks predominate. The recovery is likely to face headwinds even if the downside risks do not materialise, and a second wave would magnify that challenge.”

More fundamentally, history shows that severe economic crises have long-run impacts. Evidence from a growing body of analysis on past severe pandemics shows that they contribute to secular stagnation – this is an ominous sign given the world economy is already stuck in secular stagnation. In other words, this pandemic will reinforce a period of no economic growth at all.

The pandemic is likely to turn out most severe in emerging markets, where poorer countries face an even starker trade-off between saving lives and preserving livelihoods.

The World Bank studied four major epidemics that have occurred since 2000—SARS, MERS, Ebola and Zika—and found that in the stricken economies, they have left long-lasting scars on investment which was, on average, 11% lower five years after these events, compared with those economies not hit by these epidemics.

A recent article in an International Monetary Fund (IMF) publication looks at the 15 largest previous pandemics, going back to the Black Death in the 1300s (events with at least 100,000 deaths). It found that the European natural real rate of interest, or R-star, is, on average, tilted down by nearly 1.5 percentage points about 20 years later.

Severe pandemics lead to wealth inequality and anxiety about the future, resulting in an abundance of private saving over investment. The loss of labour without parallel destruction of capital also leads to a rebalancing of the relative returns to labour over capital. This is the opposite effect of major wars where the relative loss of capital to labour tilts the interest rate response up, not down.

Exhibit: The impact on R-star: World wars versus severe pandemics

For some perspective, a 1.5-percentage point decline in R-star is comparable to what advanced economies have experienced since the GFC, and from today’s very low level, would drive R-star below zero (and drive private sector R-star even deeper into negative territory). In short, the liquidity trap that central banks are in, is set to worsen.

A policy stimulus like never before

Unlike during the GFC, when central banks were seen as “the only game in town”, governments this time have stepped up in response to COVID-19 with very aggressive fiscal expansion to protect people, preserve jobs and prevent bankruptcies.

The IMF, in its June 2020 World Economic Outlook update, projects that the global average fiscal deficit will increase to 14% of GDP in 2020, 10 percentage points higher than last year, and global public debt will reach an all-time high.

In the advanced G20 economies, the IMF projects an even more aggressive government response, with the average fiscal deficit amounting to 18% of GDP in 2020, and public debt surging 28 percentage points from last year, to 141% of GDP.

Policymakers have learned from the GFC how important it is for monetary and fiscal policies to act urgently in unison against the most severe economic downturn in our lifetimes. They recognise the need to forcefully be “all in”, to try and limit negative feedback loops and lasting scars that caused the Great Depression.

A classic feedback loop in great recessions is from higher unemployment to lower spending to even higher unemployment. John Maynard Keynes described this in the 1930s as the paradox of thrift, and it is a real threat today as households face what Bank of England’s Andy Haldane describes as double jeopardy – risks to their lives and their livelihoods.

Another dangerous feedback loop is corporate cash flow problems triggering systemic defaults and, in turn, banking crises.

And with COVID-19 still raging, these negative feedback loops loom large.

The Fed must also be cognisant that, with the policy interest rate near the effective lower bound, R-star set to turn negative and the pace of recovery starting to slow, the real (inflation-adjusted) interest rate needs to stay deeply negative, in order to be stimulatory.

Prepare for new innovations by the Fed

In times of crises, there is a premium on being prompt and creative in policymaking. Against this backdrop, we expect the Federal Open Market Committee (FOMC) to announce several policy innovations in the not-too-distant future, aimed to buttress inflation expectations, sustain negative real interest rates and ease overall financial conditions.

We expect it to announce several innovations to increase the credibility and potency of its policy response. These may include some combination of the following:

Average inflation targeting. Seek inflation on average of 2% over time with authorisation to overshoot to offset periods of undershooting. This could be achieved by refraining from interest rate lift-off until inflation reaches 2%, or set a starting date, say, January 2020, and refrain from lift-off until inflation from that date averages 2%.

Enhanced forward guidance. State-based forward guidance in which the FOMC pledges not to start normalising monetary policy until, for example, the unemployment rate falls below a certain threshold, say 4% (it is currently 10.2%).

Yield curve control. Perhaps some variant of the Reserve Bank of Australia’s announcement in March to target the 3-year government bond yield at around 0.25%, until progress is being made towards the Bank’s goals of full employment and the inflation target.

Open-ended quantitative easing programme. The FOMC commits to an aggressive open-ended quantitative easing programme, such as asset purchases of at least $120 billion per month, until it achieves its inflation target or its maximum employment goal, or both. It could also commit to purchasing longer-maturity Treasury bonds.

Blurring boundaries between monetary and fiscal policy

Unexpectedly, the COVID-19 crisis has turned out to be the catalyst for policymakers to finally deliver on the prescription recommended by Lawrence Summers and Olivier Blanchard and the like: aggressive Keynesian-style fiscal expansion alongside unconventional monetary policy to combat secular stagnation and a likely soon-to-be-negative R-star.

Central banks may be reluctant to admit it, but the boundaries between monetary and fiscal policies have quickly become more blurred this year – and will get further blurred if, as we expect, the Fed soon introduces new monetary policy innovations.

Unconventional monetary policy has greatly helped—or in some jurisdictions, guaranteed—to keep sovereign bond yields low and, by making it cheaper for governments to borrow, has supported the massive fiscal expansions. From a legal perspective, this is not considered pure monetary financing of fiscal deficits.

Unexpectedly, the COVID-19 crisis has turned out to be the catalyst for policymakers to finally deliver on aggressive Keynesian-style fiscal expansion alongside unconventional monetary policy.

Operationally though, it is a fine line. While unconventional monetary policies have not been deployed by central banks with the primary purpose of financing fiscal deficits, they have lowered the financing costs for governments at a time when public debt is surging.

The announcement of more explicit cooperation between governments and central banks is one way to increase the effectiveness of overall policy stimulus, although the risk is that central bank independence is compromised. A possible solution is a rules-based monetary financing programme that does not require giving up central bank independence. The central bank would be legally in control in deciding the size, time and duration of the financing operation – all with a clear, predefined exit strategy in which all decisions are linked to the pursuit of the central bank’s dual mandates.

Extraordinary economic times require radical policy responses. In the not-too-distant future, more innovative monetary policies are likely, but if secular stagnation continues, the more radical step could be a rules-based monetary financing programme of fiscal deficits.

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Managing Director, Head of Global Macro Research and Co-Head of GM Research at Nomura

Rob Subbaraman joined Nomura in 2008 and is Head of Global Macro Research and Co-Head of GM Research. He manages a team of over 30 economists and macro strategists that forecast the global economic outlook and make financial market trade recommendations. Rob is also on the Nomura Executive Committee for AEJ Global Markets. Prior to joining Nomura, Rob was at Lehman Brothers for 12 years and was Chief Economist, AEJ. Rob is based in Singapore and has a central banking background, having worked at the Reserve Bank of Australia in the Economic Analysis Department for seven years prior to joining Lehman Brothers.

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