DM Monetary Policy Options Heading Into 2021

Summary

• DM monetary policy was more stable in Q3 than 2020H1; balance sheet expansion slowed.
• If further support is needed heading into 2021, options are more limited.
• The negative rate club is likely to welcome one new member: the RBNZ.
• Average inflation targeting carries some important negative risks.

Market Implications

• Medium term; Negative US equities and rates; A move up in inflation (and inflation expectations) is likely to cause an adverse market reaction with curve steepening and weakening equities.

Major DM central banks were far less active in the quarter just ended than they had been in the first half of the year. This is unsurprising, since they had largely played their hands during 2020H1. There were no changes in DM policy rates in Q3 (Chart 1). Countries with positive policy rates had reduced them to previous historic lows during H1; no country with negative rates chose to cut them further during the depth of the Covid-19 crisis, so it was unsurprising that all remained on hold during Q3. What did surprise was that most DM central banks reined in their asset expansion through Q3. The Fed’s balance sheet actually contracted (Chart 2).

If, as seems likely, the global economy wobbles into year end, financial market participants will look to central bank officials for some support. Central bankers will not want to disappoint. Their supportive narrative is likely to have three strands. First, they will emphasize the massive dose of support administered to date, underlining that some patience is needed for it to work effectively. Second, many will emphasize that fiscal policy is better placed to handle many of the structural changes needed to address the long-run consequences of Covid-19; monetary policy can help by providing adequate financing for persistently higher budget deficits. Finally, there will be an effort to highlight that there is scope to do more, even though, realistically, monetary policy looks maxed out. Two options will be emphasized: the possibility of even lower rates (for the RBNZ and BoE, this might mean negative rates); and the possibility of allowing inflation to accelerate above target for a significant period. In my view, a risk of both these approaches is that they will cause more damage than good.

Factors Behind Slower Balance Sheet Expansion

There are three general explanations behind the sharp slowing in DM central bank net asset accumulation during Q3. These all reflect improved global financial conditions. And they are therefore consistent with a narrative that the powerful cocktail of QE drugs provided between March and June served to provide sufficient support to restart financial markets.

First, DM cash budget deficits have generally fallen through Q3, implying less need for immediate central bank funding. Second, the dramatic tightening in debt spreads from their March peak underlines that private sector credit intermediation has been restored for creditworthy borrowers. Central banks are only in the business of lending to them (‘we have lending power, not spending power’). Finally, support of cross-border funding markets through currency swaps has been dramatically reduced. They fell to just $1 billion at the end of Q3, down from $60 billion at the end of Q2 and $287 billion at the end of Q1.

The Bank of Japan has been steadiest in its balance sheet expansion policy in 2020. This is because it has stepped up its net securities purchases after a number of years when its yield curve control (YCC) policy allowed it to dial back outright buying. Moreover, it has expanded both its non-JGB buying and, especially, its domestic lending programs in order to support the domestic corporate sector.

The slowing in net asset acquisition by the ECB during Q3 was the result of a net slowing in loan growth, accompanied by a dialling back in the pace of net securities purchases (Chart 3). Net purchases under the Pandemic Emergency Purchase Program (PEPP) were €85 billion in July and €59 billion in August, down from a Q2 average of €113 billion.

Eight of the nine jurisdictions in my DM central bank sample have domestic QE policies (the SNB operates through FX assets). Of the eight, two operate YCC policies (RBA and BoJ); two have open-ended discretionary QE policies (Fed and BoC); and four have stock-based QE targets (ECB, RBNZ, BoE and the Riksbank).

When thinking about upcoming announcements of ‘more’ monetary policy easing, there is an obvious question: how far are central banks with stock targets from bumping into them? The BoE is closest to hitting its ceiling (Chart 4). As of 23 September, it was about £40 billion away from its agreed ceiling. At the net purchase rate of the last four weeks, that would give it another eight weeks of buying (end November). This makes the announcement of a further £100 billion QE expansion at the 5 November Monetary Policy Meeting highly likely. The meeting comes just after the formal ending of the job furlough program; by early November, the final status of the new UK-EU trade regime should also be apparent. By contrast, the other three jurisdictions have used up only about a third of their (current) QE capacity to date (Chart 5).

The ECB has promised to continue with the PEPP at least until June 2021 and its smaller regular QE program (APP) until ‘shortly before it starts raising the key ECB interest rates’ (unlikely until beyond 2023). There is no pressing need for an acrimonious debate about more QE until the end of 2021Q1, by which time the post Covid-19 world might look clearer.

Options Remaining

A third narrative from DM central banks is, ‘we are not out of bullets’. It is understandable that central bankers are keen to stress this line. Since 2008, they have increasingly been seen as the ‘go to’ force in global economic management and have enjoyed basking in that limelight. It is an uncomfortable notion that they might not only be maxed out but also in a position that their efforts have left the economic conjuncture dangerously unbalanced.

There are indeed some bullets remaining. Among my nine-country sample, Australia, Canada and New Zealand all have some scope to cut their 25bp policy rate slightly. For most others, the most obvious near-term tactic would be to reaccelerate the pace of QE purchases. This is especially true for the Fed, which slowed its net securities purchases significantly during Q3 (Chart 6). The RBA also has some scope to compress term premia further by buying longer-term debt (under its YCC program, purchases have been out to three years). The BoJ, ECB, BoE and RBA have attempted to boost net lending to the economy by expanding funding programs for banks. The RBNZ plans to introduce a Funding for Lending Program during Q4. The Fed has had more difficulty in starting its lending program. The Main Street Lending Program was created with a capacity to buy up to $600 billion in loans. Almost six months on, it has just passed the $2 billion mark. The main reason for this is demand: the banking sector remained far more resilient through the crisis than feared in early April.

Another tactic would be to rely on FX intervention, as has the SNB through the past decade (without which, the Swiss franc would have been presumably markedly stronger). This tactic seems most likely to be followed by the RBNZ and, possibly, the RBA. The downside is that it smacks of ‘beggar-thy-neighbour’ and is likely to attract the wrath of the US Treasury.

The Final Frontier: Negative Policy Rates

The scope for interest rate cuts remains everywhere if there is the ability to implement negative interest rates. The market now prices negative rates in both the UK (Chart 8) and New Zealand during 2021H1. I think the RBNZ is likely to make such a move; the BoE will probably not. I do not expect the other positive rate central banks in my sample (RBA, BoC and the Fed) to make such a move.

In my view, the net stimulative benefits of negative rates are far from obvious. They work through two transmission mechanisms. First, they can weaken the currency if they are bold enough (this may be the main route of focus for the RBNZ). The efficacy of this channel is damaged in a zero-to-negative interest rate world, however. Second, they are supposed to stimulate domestic demand by lowering lending rates. There is growing evidence that this channel works poorly, especially in economies where credit intermediation is dominated by banks, for whom negative rates are a tax.

Revealed preference is a powerful tool in economics. Perhaps the most damning evidence of negative rates’ inefficacy is that no central bank already with them when the Covid-19 crisis began has chosen to use them further during 2020.

New Forward Guidance: Average Inflation Targeting

The current plan for most DM central banks for 2021 and 2022 is to sit back and let existing policies work. The result is that the horizontal line in Chart 1 is likely to extend further right in coming quarters (contrast with 2010 onwards). Forward guidance on intended rate policy is mostly qualitative (Table 1).

The Fed has recently taken a step that other central banks will likely follow in 2021: commit to ‘average inflation targeting’. The basic notion is that having consistently undershot the 2% inflation target since its inception in January 2012, it would be appropriate to exceed it ‘moderately’ for ‘some time’ such that inflation averages 2% over the cycle.

I think there are two huge problems with this approach. First, the post-2012 inflation experience was not an outlier, but fully in line with the experience since 1995 (Chart 9). Committing to keeping policy at its easiest possible stance until an unusual condition is met seems like an odd strategy. Second, and even more concerning, how much is ‘moderate’? If inflation starts to move up (pulling up expectations), is that a good thing? What would tell the Fed that this move up was too much of a ‘good thing’? In my view, it would most likely be an adverse market reaction, (curve steepening and weaker equities) raising the spectre of the Fed hiking into a tightening in financial conditions (and rising debt-service difficulties). Welcome back to the 1970s.