Central banks and governments are facing many challenges as they consider the best policy response to stimulate the economy post COVID-19. With the pandemic hitting at a time of historically low interest rates, governments intervening through loan guarantees and a banking system grappling with falling loan demand, policymakers have limited options on the table. So, what can investors expect to see over the next 12 months and beyond and how should they adjust their expectations?
A CENTRAL BANK CONUNDRUM
Ahead of the COVID-19 pandemic, the world had already shifted into a coordinated easing cycle to combat the impact of a slowing economy.
By the time the pandemic struck, interest rates in many countries were already near historic lows. This left central banks with two obstacles: there was little room to cut rates any further and the disruption to business supply lines and demand meant the impact of low rates was not enough to kick start the recovery.
Central banks moved from stimulating the demand for money to increasing money supply through quantitative easing.
Although previously used by Japan, Europe and the United States during crises, emerging markets had shied away from this measure, fearing it would lead to inflation and capital flight. However, given the unique nature of the pandemic, inflation has been absent from the current environment for the most part. Some emerging market central banks including India, South Africa and Turkey have begun to engage in long-term government asset purchases.
LOWER RATES FOR LONGER
As yield opportunities have fallen dramatically, one might expect that capital is seeking out higher relative yields. But for the most part, markets have been more concerned with growth over yield or better said, yield without growth is not attracting foreign capital.
Investors are not as attracted to the delta on growth (quarter on quarter seasonally adjusted annual rate), but the level of growth and speed at which national economies will return to pre-pandemic nominal gross domestic product.
Given the need to prioritize growth, central banks will err on the side of easing for a prolonged period rather than easing too little and risking a low inflation rut.
Even in countries such as Turkey, where inflation is becoming an issue, there has not been any discussion of rate hikes yet. While in Mexico, central bank governors have agreed on cutting rates further with the only dissenting views focused on how low they should go.
What could change the minds of monetary authorities? Persistent demand-driven inflation in a wide basket of ex-food, ex-energy items would likely change central bankers’ views on low rates. However, without a widely available and accepted vaccine, broad-based inflation in most markets is not likely to happen. A weakening dollar is also helping to shelter emerging markets from imported inflation, providing those countries with more cover to keep rates low.
DEFLATION REMAINS A CONCERN
Many central banks are just as worried about the insidious problem of deflation as they are with inflation.
This seems counterintuitive given the low interest rates and widespread money printing – where even emerging markets are monetizing their own debt – but, there are two powerful trends driving disinflation, if not a deflationary effect.
The first is structural. In modern history and especially in developed markets, high inflation has been largely theoretical outside of commodity shocks. Even as low rates have driven financial asset and real estate inflation over recent decades, goods and services inflation as measured by statistical offices has been benign.
Technology has played a significant role in this. Advancing technology creates rising productivity and lower prices. Consumer goods, media, entertainment, healthcare, financial services and automotive and agriculture are all being enhanced or replaced by technological productivity gains, driving prices lower by scaling distribution. COVID-19 has provided a turbo boost to many of these trends.
The second factor is transactional. Central banks aim to control the flow of liquidity; however, for the most part, the actual creation of money happens in the commercial banking system. Central banks use market operations to control the very short end of rates, but money supply grows as commercial banks create and expand credit.
This can be tracked in some markets due to transparent data and filings, especially in the US. The aggregated transactions and assets at commercial banks can help us measure whether conventional monetary policy (rate adjustments) and unconventional policy (buying of debt instruments) are creating more liquidity.
The targets of current stimulus measures have been quite broad, with programs aimed at helping large and small businesses as well as ordinary consumers, but the impact on bank credit expansion was short-lived.
The US Federal Reserve (Fed) certainly prevented a deeper and longer liquidity crisis from devastating the global economy in March with repo, swap and purchase facilities that backstopped the flow of capital.
Meanwhile, the US Treasury’s loan guarantees enticed banks to make loans that they may not have otherwise made. In a downturn, commercial and industrial lending demand falls, requiring banks to look elsewhere to grow credit. In the early stages of the pandemic, the exact opposite happened due to the policy response. However, the fiscal policy response did have constraints on eligibility, amounts offered and time available, which quickly receded the early surge of lending. In the US, when loan demand falls, commercial banks have another alternative: they can buy government or agency debt, expanding credit through securities markets.
As rates collapsed toward zero, the marginal benefit of buying securities versus holding cash on deposit at the Fed fell too. Banks were not buying securities at the level to which lending was drying up. Remarkably, total credit in the US commercial banks has been flat since the end of April. After the initial surge in guaranteed loans in March and April, transmission of monetary policy has been nearly non-existent in aggregate in the US.
More recently, banks have been participating in the mortgage market again. A large part of the demand has been for refinancing existing loans to lower rates. This should be a net positive as banks earn and consumers have more money in their pockets, potentially boosting retail spending. But this activity may be muted by surcharges from agency securitisation firms as they look to protect their capital base to emerge from government conservatorship.
As of now, mortgage lending is carrying the weight of a banking system which is neither lending nor buying treasuries in sufficient quantity to replace the drop in lending.
This does not bode well for policymakers seeking to support the real economy. Outside the US, other monetary authorities are pausing rate cuts to weigh the strength of loan demand and the likelihood that cuts will be passed on to consumers.
China has halted a reduction to its loan prime rates, which affects corporates, mortgage issuers and consumers as it gauges the effectiveness of its current policy transmission.
There are limits to the effectiveness of monetary policy when rates approach zero and real rates turn negative. The reality is that demand elasticity in the unique conditions caused by a pandemic is significantly less than one. Loan demand and higher rates are possible only once the damage from the potential spread of COVID-19 is minimized through immunity or therapeutics.
Daniel Gerard is senior multi-asset strategist at State Street Global Markets.
