As the global economy shows signs of moving from despair to repair, both monetary and fiscal policies will prove critical. Monetary policy (interest rates and the money supply) is the domain of central banks, while fiscal policy (tax rates and public spending) is, of course, set by governments. Daniele Antonucci, chief economist at Quintet Private Bank, writes

To vastly oversimplify, central banks are lenders and governments are spenders.

Today, the global economy is being supported by both more lending and more spending, as central banks fund their governments’ stimulus measures, so together they can do whatever it takes – and for as long it takes – to repair their respective economies and set them on solid foundations for healthy future growth.

The policy impulse is strong because there is no moral hazard like there was during the 2008 financial crisis, when banks took large risks and, subsequently, had to go through a long process of deleveraging. Following a decade of tighter regulations, the banking system is now in a solid position and can deploy its healthy balance sheet to support the recovery.

Funding and spending

Central banks are providing a cheap source of funding for government spending programmes through their asset purchases, known as quantitative easing. And they are buying corporate bonds too, thereby injecting money into the private sector.

Although formally monetary policy, this approach is an indirect form of fiscal policy because it has to do with allocating resources to non-financial corporates. In that regard, think of central banks as a bit like referees for the economy and markets.

Part of their job is to ensure that everyone understands the rules; they also sometimes need to encourage or discourage certain kinds of behaviour through verbal intervention. And, when necessary, they administer yellow or red cards in response to actions that are beyond the pale.

A good example of such a penalty card is negative interest rates. Charging banks for parking liquidity with the central bank, as the European Central Bank continues to do, is a way to incentivise them to lend to the real economy. Until now, however, that has not gone quite according to plan.

YCC

Rather than fully passing along the cost of negative rates to customers, European banks have generally compressed their profit margins. It may have also made them more reluctant to extend new loans. The side effects of negative rates are such that we believe – even though markets have assigned some probability to the introduction of negative rates in the US and the UK – the next step in these countries is likely to be yield curve control (YCC).

YCC involves targeting a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit that rate target. If that sounds similar to quantitative easing, that is because it is – but quantitative easing deals in quantities of bonds, while YCC focuses on bond prices. YCC has been practised for years by the Bank of Japan. Australia’s central bank adopted a form of YCC in March, and is targeting a three-year government bond yield of 0.25%. Now, US Federal Reserve officials are debating whether to introduce YCC.

Government measures

The US federal government has spent about $3.5trn since the start of the pandemic to shore up the economy, contributing to a national debt that just topped $26trn for the first time in history. In Europe, national governments have boosted their spending programmes, too.

Importantly, negotiations are ongoing to establish a European recovery fund backed by joint issuance – a key catalyst for increased fiscal integration.

While no one can predict the future path of the pandemic – and the global recovery is likely to take place at different speeds in different regions – it is clear that central banks have not exhausted their policy options and that governments will continue to pull out all the stops.