Policy revolution

Speed and size

We have witnessed a revolution in macroeconomic policy in response to the coronavirus shock. The speed and size of the response has been greater than at any other moment in peacetime history. The core tenets of global policy frameworks and markets have been fundamentally transformed.

^{Sources: BlackRock Investment Institute and finance ministries, June 2020. Notes: The chart shows actual and expected fiscal spending measures and actual loan guarantees across selected developed market economies. We add an area of potential increase to the U.S. loan guarantee bar because the structure of the U.S. programs means they can be scaled to be larger than what has been formally announced. Forward looking estimates may not come to pass.}

The scale of the fiscal policy response has surpassed the GFC in terms of discretionary fiscal stimulus and government guarantees. See the Serious fiscal support chart above. Fiscal policy mobilization on such a scale has not been seen since World War II. And in some cases, the fresh round of emergency stimulus comes on top of already sizeable budget deficits and steep upward trajectories in public debt.

The policy revolution has three main parts. First, the new policies are explicitly attempting to “go direct” – bypassing financial sector transmission and finding more direct pipes to deliver liquidity to a larger set of entities. These include businesses, households and foreign central banks. This is in return for a broader set of collateral such as corporate bonds and bank loans, up to and including the Fed’s Main Street facilities. The ECB and the BOJ had already made baby-steps in that direction, but all central banks are now moving into unchartered territory. The U.S. and UK fiscal authorities are explicitly backing this type of central bank lending and in turn are starting to rely on direct borrowing from the central bank at the local government level. The chart below shows how important these direct policy instruments have become relative to the traditional unconventional toolkit. In the euro area, the main innovation is the pandemic emergency purchase programme (PEPP) that allows the ECB to buy government debt out of proportion to euro area country shareholdings in the bank.

The second aspect of this revolution is the explicit blurring of fiscal and monetary policies. The policy instruments represented by the green areas in the top chart below all involve credit risk that is explicitly backed by the U.S. Treasury. This is fiscal policy working through a Fed instrument. Boundaries have also been blurred in the use of monetary policy to keep interest rates low – buying government debt as fiscal spending surges. Aside from the few places where it is explicitly presented as yield curve control, large or even unlimited asset purchase programs are tied to maintaining low government bond yields. Temporary monetary financing has been made explicit In the U.K.

The third aspect of the policy revolution is the stringent conditionality around dividend payouts, share buybacks and executive compensation imposed on companies taking government support. This opens the door to unprecedented government intervention in financial market functioning and corporate governance.

Point of no return

This global policy revolution was inevitable and is largely going in the direction as we discussed last August. We also stressed at the time that closer coordination between monetary and fiscal policy would be a slippery slope without proper guardrails and a clear exit strategy.

^{Sources: BlackRock Investment Institute, US Federal Reserve and the US Bureau of Public Debt, with data from Haver Analytics, May 2020. Notes: This chart shows the net issuance of government bonds in the US, and the government bond buying program of the Federal Reserve.}

The risk now is that we start sliding down that slope. We have crossed the Rubicon in terms of fiscal and monetary policy coordination. Central banks are becoming ever more vulnerable to political interference and pressure as they increasingly implement policies that have clear fiscal dimensions. Currently the Fed is implementing credit support policy (as a banker), but the Treasury owns the credit risk (as the ultimate owner of the special purpose vehicle). Who gets to decide when to stop and on what basis?

The blurring of the boundaries can be illustrated by comparing net government bond issuance to central bank purchase programs. See the chart above. In the case of Japan, the formal adoption of yield curve control has pushed BOJ purchases well above net issuance in the past few years. The same has happened in the euro area as the ECB has tried to contain sovereign spreads since 2015. Now the Fed has dramatically picked up the pace of its bond purchases to keep up with the Treasury’s net issuance. If purchases climb above net issuance, this could be interpreted as a more deliberate attempt to put a lid on bond yields. Observing a closer correlation between the pace of purchases and the pace of net issuance – as seen in UK in the past – would be a further indication of boundaries becoming blurred.

The way out

It’s important to have a clear exit strategy. Otherwise, it is not clear how policy makers would put the genie back in the bottle. There a is need for continued monetary policy coordination to avoid an uncontrolled rise in long-term yields. This implies that central banks will absorb new debt issued by governments. This amounts to de-facto debt monetization if it's done on a large scale and over a long period – even without public entities directly tapping the central bank (as it is now the case for the BOE). Without an exit strategy from the government debt purchases or from yield curve control, it is not clear what check and balance prevents full-blown uncontrolled fiscal spending (e.g. Modern Monetary Theory).

^{Sources: BlackRock Investment Institute, August 2019. Notes: These stylized charts show the hypothetical impact of a temporary increase in fiscal stimulus financed by the central bank, as reflected in the SEFF funding (red line in top chart). The other red lines show the impact on the inflation trend relative to the inflation target (dotted line on bottom chart) and on the long-term sovereign bond yield (middle chart). The yellow lines show the hypothetical outcome if there is no stimulus. For illustrative purposes only. There is no guarantee that any forecasts made will come to pass.}

There is a clear need for an institutional framework to enable an exit. We have suggested one that explicitly ties the exit from the joint monetary-fiscal policy effort to the inflation outlook and financial stability assessment. This is what our Standing Emergency Financing Facility (SEFF) – sketched out below – could achieve. It needs an ex-ante commitment from central banks and governments to an institutional framework guiding policy coordination. If this institutional void is not filled, markets could see high inflation outcomes as we did under Fed chairs during the 1970s. Getting inflation under control would require implementing painful policies such as former Fed Chair Paul Volcker's play book in the early 1980s: high interest rates to dampen inflation.

In the near term, policy fatigue is a risk. The most acute risk is in the U.S., where fiscal support has been delivered via discretionary programs rather than through automatic stabilizers associated with the euro area's welfare. This means the support can be turned off abruptly. The debate in the U.S. on extending and expanding support for unemployed workers, disrupted businesses, and states and localities is likely to heat up. And the bipartisan effort to pass the nearly $3 trillion of fiscal support to date may succumb to partisan politics on the next tranches of aid, starting around deadlines in the coming weeks. The upcoming presidential election only adds to the political complications.

Europe faces its own problems. Both Italy and Spain are governed by potentially unstable coalition governments. Germany’s Merkel oversees a weak coalition and is still planning to step aside. France’s Macron has lost his outright majority in parliament due to defecting lawmakers. And populism remains a potent force in many countries, helping exacerbate a drift toward European fragmentation and geopolitical tensions such as those between the U.S. and China. See the European fragmentation and U.S.-China relations risks on the BlackRock geopolitical risk dashboard.