The ECB’s decision last week to cut its policy rate and restart QE caused an unusual amount of disagreement, with a parade of central bank governors loudly voicing their opposition. Yet amid all the discord, the ECB governors were unanimous on one point: that fiscal policy should now take the baton from monetary policy as the main instrument to stimulate the economy. What is driving this increased focus on fiscal policy, and how likely is major fiscal stimulus?
Monetary policy side effects: Central banks have unleashed an extraordinary amount of monetary experimentation over the past decade, with over $11 trillion of QE and negative policy rates as low as -0.75%. They are now wondering how far they can push unconventional policies like negative rates, given the side effects such as impaired banking sector profitability. We don’t think we have yet reached the limits of negative rates. There is little evidence of cash hoarding to escape the negative return on large bank deposits. And for all the challenges to bank profitability, banks are still transmitting easy monetary policy to their customers via lower interest rates on consumer and corporate lending. All that said, we do think that pushing negative rates much lower than, say, -1% would probably require limits on cash holdings, quite a controversial step. Otherwise, the incentive to avoid negative rates by holding cash, yielding zero, would be too great.
Monetary policy effectiveness: The other main critique of unconventional monetary policy is that, while it may have been helpful in the depths of the crisis, it is at this stage only boosting asset prices, with little impact on growth or inflation. We do think that QE is still helpful, especially in easing funding costs in the Eurozone periphery. But we agree that fiscal policy would provide a more powerful boost to the economy. After all, monetary policy can only lower funding costs; it can’t force consumers, corporations and governments to spend. Fiscal policy directly increases spending in the economy.
An invitation from the bond market: Bond markets are inviting governments to spend. A case in point is the US, where the government deficit is rising with unemployment around its lowest in decades, precisely the opposite of the usual countercyclical approach to fiscal policy. Far from protesting at this, US Treasury bonds have flirted with all-time low yields over the past month. A different case is Italy, where bouts of political uncertainty have caused significant spikes in yields over the past few years. Even so, Italy’s debt has been steadily rising, while yields are also close to all-time lows.
Inflation expectations are low: For all their monetary inventiveness, central banks have failed to arrest the fall in inflation [in most countries] and inflation expectations [almost everywhere]. Quite apart from boosting growth, and – if well-designed – potential growth, easier fiscal policy could provide the impetus needed to reanchor inflation expectations closer to central bank targets. Some of the loudest calls for fiscal easing recently have come from advocates of money-financed fiscal expansion, based on Modern Monetary Theory [see the critique from my colleagues Ed Fitzpatrick and Kelsey Berro here – MMT: Short-term gain vs. Long-term pain]. But a more measured version of the same theme is simply that currently depressed inflation expectations provide scope for fiscal expansion.
Political constraints: In the near term, we see quite a few political constraints preventing governments from accepting the bond market’s invitation to spend. The US has a divided Congress heading into an election year. The Eurozone, and especially Germany, is constrained by constitutional borrowing limits, reflecting an ingrained aversion to government debt in many countries. We do expect some fiscal easing from Germany, but it is more likely to be a modest package, in line with the Federal government’s 0.5% of GDP wiggle room relative to the constitutional debt brake, than a fiscal bazooka. Japan is implementing some fiscal measures, but only as a counterpoint to a long-planned increase in sales tax. The UK is one developed economy where the fiscal narrative has clearly turned, and whichever government presents the next budget is going to turn the page on a decade of austerity. All told, that still leaves the onus on central banks to support the economy for now.
Watch elections, and Japan: In the medium term, we think the main policy response to the next recession will be fiscal stimulus, coupled with QE to absorb the resulting increased supply of government bonds. The trigger point for the shift could be economic weakness, or elections in which a platform of borrowing to spend at these very low yields proves a winning proposition. Japan’s economy and markets have long been a harbinger of what was to happen elsewhere. In recent years, the Bank of Japan has been hoovering up the Japanese government bond market, with limited success in pushing inflation higher. But importantly, instead of using this monetary support as an opportunity to spend more, the Japanese government has so far been reducing its deficit. In Japan and elsewhere, we will be watching closely to see when the baton is passed.
Following the Fed’s announcement, please see below for market views from the Global Fixed Income, Currency & Commodities Team (GFICC):
The Federal Open Market Committee (FOMC) cut the Fed Funds rate target range by 25 bps to 1.75% ‐ 2.00%. The post-announcement reaction was mixed with risk assets underperforming and the Treasury yield curve flattening. While Chair Powell communicated a willingness to adjust policy to sustain the expansion, he was hesitant to commit to the additional rate cuts that financial markets are pricing for 2020. In addition, he did not address a permanent solution for the concerns within the short-term funding market. He continues to view recent adjustments in the context of insurance against downside risks rather than the start of a longer easing cycle, although he avoided explicitly characterizing it as a “mid-cycle adjustment”.
The September FOMC statement maintained most of the language used in July including the comment that the Fed will act as necessary in order to sustain the expansion but also noted that trade uncertainty is broadening to other sectors, specifically exports. While the Committee still expects a strong labor market and 2% inflation as the most likely outcomes, the statement maintained mentions of uncertainties in conjunction with muted inflation pressures as reasons to closely monitor the data.
The Summary of Economic Projections reflected two camps: seven participants are looking for an additional cut in 2019 while five set their projections 25bps above the current rate.
Formally, there were three dissenters at the meeting, Esther George and Eric Rosengren both preferring to keep interest rates unchanged while James Bullard preferred to cut rates by 50 bps.
The interest on excess reserves and reverse repo rate were also adjusted down by 30 bps each to help keep the Fed funds rate trading in the new range.
We can break the statement into two parts:
Summary of Economic Projections
Chair’s Press Conference
Chair Powell spent much of his time explaining the Committee’s rationale for easing monetary policy for a second time this year while also indicating that their base case of low unemployment and stable inflation remains unchanged. He continued to highlight the growing gap between the weak global growth backdrop and softening US manufacturing sector in contrast to the continued strength in the US labor market.
In general, Chair Powell showed little immediate concern for the US economic outlook. He dismissed the slowdown in payrolls growth as expected and indicated the consumer is still very strong. On the inflation side, Chair Powell continued to express the risk that inflation expectations could slide lower but also noted that realized inflation was rising closer to their target more recently.
Rather than focus on the number of additional rate cuts he expected, Chair Powell repeated the Committee’s desire to “sustain the expansion” and that they will adjust policy as appropriate to do so. While he mentioned it could be in theory better to be “proactive” as an approach to monetary policy, in reality the Committee was taking their decisions “meeting by meeting” and policy was not on a “pre-set” course.
Many reporters asked questions focused on the repo funding market and the rise in short-term lending rates experienced by financial markets this week. In general, Chair Powell dismissed these concerns as having little implication for the broader economy. He communicated that for now, they would address these funding strains using temporary open market operations such as the overnight repo operations the NY Fed has now conducted for the past two days rather than announcing more permanent solutions to address the issue.
Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.