Policy revolution

Outlook

Macroeconomic policy has gone through nothing short of a revolution in just two months. The policy response is on a completely different scale compared with the global financial crisis (GFC). Not only has the response been faster and the scale greater than at any moment in peacetime history, but core tenets of global policy frameworks and financial markets have been fundamentally transformed.

Source: BlackRock Investment Institute and the Federal Reserve, with data from Haver Analytics, June 2020. Notes: The chart shows what the Fed's balance sheet could look like by the end of 2020 with the new facilities launched in the past two months compared with March 6 – just before it began its interventions. The balance sheet at the end of 2020 is based on estimates made by BlackRock's Global Fixed Income economics team. These projections are based on data from the Fed’s H.4.1 (balance sheet) release and on the structure of the Fed’s facilities found on the Fed website. The purchase pace of securities is listed on the New York Fed website. The estimates also assume that the Fed will increase its planned support for its Paycheck Protection Program loan facility and expand its support for states and municipalities by several hundred billion dollars compared with the initial announcements. By comparison, the Fed pledged as much as $2.3 trillion in loans to support the economy in its April 9 announcement. Estimates of the expected increase and December 2020 totals are rounded. The funding facilities (green bars in top chart) are funded with credit loss protection provided by the U.S. Treasury and lending by the Fed. These programs also include the Term Asset-Backed Securities Loan Program and Municipal Liquidity Facility.

• There are three main aspects to this revolution. First, the new set of policies are explicitly attempting to “go direct” – bypassing financial sector transmission and instead finding more direct pipes to deliver liquidity to households and businesses. Second, there is an explicit blurring of fiscal and monetary policies. Third, government support for companies comes with stringent conditions, opening the door to unprecedented government intervention in the functioning of financial markets and in corporate governance.
• This policy revolution was inevitable given that the monetary policy space was insufficient to respond to a significant, let alone a dramatic, downturn. We discussed this in our paper Dealing with the next downturn in August 2019 We have crossed the Rubicon in terms of fiscal and monetary policy coordination. As central banks are increasingly implementing fiscal policies, they are becoming even more vulnerable to political interference and pressure.
• Without proper guardrails and a clear exit strategy, it is unclear how policymakers are going to put the genie back into the bottle. There will already be a need for central banks to absorb much of the debt issued by governments for some time to avoid an uncontrolled rise in long-term yields. And at that point, what will prevent governments from financing new spending in the same way? This opens the door to uncontrolled deficit spending with commensurate monetary expansion and ultimately inflation.
• A clear exit strategy is required. 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. An orderly exit could be very difficult without an ex-ante commitment to a governance framework. And to be credible, this exit decision will need to be independently controlled by the central bank.
• Many of these policy-related risks would be mitigated if the economy and markets quickly return to a more normal environment. But the longer heavy policy lifting lasts, the more that ad-hoc policy coordination will raise fundamental questions about the functioning of financial markets and the distortions of government interventions – and who truly bears the financial risks associated with monetary policy innovations and corporate bailouts
• The policy revolution is key in the near-term to ensure that this real shock doesn’t morph into a financial crisis. We see implementation risks as well as the potential for policy fatigue. A German high court ruling threatens European Central Bank independence, and the proposal for a euro area recovery fund needs the buy-in of all member states. In the U.S., partisan politics in an election year may prevent a follow-up on the fiscal stimulus to cushion the pandemic's impact.
• A change towards a higher inflation regime is a risk in the medium term, with the lack of a clear exit strategy risking a de-anchoring of inflation expectations in an environment where deglobalization and re-regulation could push costs higher.
• Given that going direct implies relying less on lower interest rates, portfolio rebalancing and inflating asset price values to deliver stimulus, the playbook of 2008 and its aftermath doesn’t apply. So on its own, this policy revolution is unlikely to be the prelude of a decade-long, policy-fueled bull market for risk assets.

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.

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).

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.