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Key to policy response

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.

Conclusion

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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