Why big fiscal deficits and low inflation can coexist

• ▀ The surge in government debt caused by ballooning fiscal deficits is a necessary response to the coronavirus crisis. But we doubt this will lead to a burst of inflation in the advanced economies (AEs), let alone a debt crisis.
• ▀ Our fiscal forecasts assume AEs’ budget deficits averaged 20% of GDP or so in Q2. However, our deficit forecasts point to a sharp narrowing thereafter and for public debt as a share of GDP to peak in 2021.
• ▀ The risks around this forecast skew firmly towards deficits remaining wide, reflecting the balance of risks around our GDP forecasts and the possibility that governments allow some fiscal slippage.
• ▀ A slower narrowing of fiscal deficits than we forecast wouldn't automatically lead to a period of above-target inflation. Indeed, we wouldn't be surprised if larger-than-expected deficits were associated with weak inflation.
• ▀ High levels of corporate debt and weak labour markets raise the risk of private sector retrenchment ahead. In that case, large and sustained fiscal deficits may be needed to fill the vacuum and prevent GDP and inflation from falling. As has been the case in Japan over the past 25 years, large deficits over coming years could be associated with weak GDP growth and below-target inflation.
• ▀ If economies begin to overheat but governments keep fiscal policy loose, inflation could, of course, pick up. But central bank tightening would offset it. We believe the risk of sustained inflation overshoots is limited unless monetary policy were made subservient to governments’ own objectives. And we think the risk of central banks losing independence remains slim.

     

Why the MPC is unlikely to join the negative rate club

• ▀ The economic shock from the coronavirus has warmed up the MPC's long-held coolness toward negative interest rates. But we think there are a number of reasons why such a move is unlikely.
• ▀ While taking rates below zero could lower banks’ funding costs and encourage lending, the net economic effect is ambiguous. Also, ‘sticky’ deposit rates would hit banks’ already strained profitability, risking paradoxical effects.
• ▀ The MPC has better-targeted tools available to it. If the MPC wanted to lower borrowing costs, increasing the generosity of the Term Funding Scheme could deliver the benefits of negative rates while reducing adverse effects. And the present scale of fiscal support reduces the need for looser monetary policy.

     

Why the surge in savings won't last

• ▀ The coronavirus lockdown caused UK savings to surge. We think the household saving ratio will average over 15% in 2020 - almost twice its long-run average - while the corporate sector is likely to run a hefty financial surplus.
• ▀ Evidence suggests that economic shocks usually push up the desire to save, to the detriment of growth. But the uniqueness of the Covid crisis and its aftereffects could limit the extent of the private sector's increased prudence.
• ▀ Scarred by recent events, consumers may remain thriftier as normality returns. But the short duration of the economic contraction and the windfall nature of lockdown savings mean any long-term rise in savings rates could be modest.
• ▀ Meanwhile, post-pandemic, a more cautious attitude to investment and efforts to repair balance sheets suggest higher saving by firms. But the prospect of weak corporate profit growth will, in our view, offset those forces.

     

Soaring corporate debt is a risk to global growth

• ▀ Corporate borrowing is accelerating as a result of the coronavirus crisis. In part, this is a healthy development as firms look to ride out a period of low or even zero sales. But it also brings potential risks to growth, especially in the longer term, including via lengthy balance sheet restructuring that hurts investment and productivity growth.
• ▀ In the advanced economies, we estimate the aggregate corporate debt/GDP ratio could rise as much as 10ppts in 2020, to 95% of GDP - well above the 2009 peak. Debt service ratios may also rise into risky territory despite low interest rates. Risks look especially elevated in France and Canada.
• ▀ Evidence for both advanced and emerging economies suggests high corporate debt levels can damage growth. Highly indebted firms tend to invest less in both the near and medium terms, and some estimates suggest the rise in aggregate debt this year could cut GDP growth by up to 0.2% per year.
• ▀ The coronavirus crisis may also crystallise some pre-existing risks in corporate debt. Despite government assistance, defaults by low-rated firms have started to rise and commercial real estate prices are falling.
• ▀ Sectoral concentrations of risk may also be intensified and new ones created in industries hit hard by the virus like energy and consumer discretionary sectors.
• ▀ Emerging market corporate debt is also on the rise - sharply in some cases. In some economies, this mostly reflects exchange rate effects. But negative balance sheet effects of this kind are also a risk to growth.

     

Don't expect a big lift from central bank policy easing

• ▀ During the current global slowdown, the world's central banks have delivered a broad-based policy easing that has been larger than during the previous two mini-downturns of the current cycle.
• ▀ We expect this to halt the downward momentum in the early part of this year and is a key factor behind our baseline view of no global recession in 2020.
• ▀ But limited further central bank wriggle room or a reluctance to use it adds a question mark over the efficacy of monetary policy and means we doubt it will deliver a big growth bounce, particularly in the advanced economies. In addition, fiscal support is likely to be limited in 2020.

     

Why deflation may be a bigger risk than inflation

• ▀ Concerns about high inflation in the medium term are in our view overdone. In fact, we think the bigger risk is some economies sliding into deflation, due to the coronavirus pandemic's long-lasting negative impact on demand, which will intensify existing global disinflationary trends.
• ▀ We do not think the recent acceleration of monetary growth will lead to rapid inflation, despite the strong historic relationship between the two. The current monetary growth is taking place in extremely unusual circumstances, which may alter the usual link with inflation, and may also be temporary.
• ▀ Meanwhile, most market-based measures of deflation risk have risen recently – in some cases to historic highs. Some household surveys point to slightly higher inflation, but this may reflect short-term volatility in prices for key goods.
• ▀ A slide into deflation would have a variety of negative consequences, including feeding back into private saving, weakening growth, and potentially raising debt sustainability issues in some economies.

     

G7 consumption: after the wealth rush

• ? In only one of 12 large advanced economies do we expect consumption to outstrip GDP growth in 2018. As key drivers rotate, the impact of a recovery in real incomes will be dampened by higher oil prices and waning wealth effects .
• ? Policy‐fuelled asset booms sustained the post‐crisis recovery in G7 consumption, though by historical standards the recovery was nothing special. Historically, the G7's average 5‐year recovery from troughs entailed consumption matching GDP growth, but in the five years from 2010 consumption was 0.2 ppt weaker. Its relative strength only picked up from 2015, when boosted by weak oil prices.
• ? Relatively weak G7 consumption growth is likely to continue as key drivers rotate. Strong employment growth and a modest pick‐up in wage inflation will offset waning equity and housing wealth effects.
• ? Near‐term risks are two‐way. An oil‐fuelled inflation surprise could hit consumers, wreck central bank gradualism and reveal balance sheet weaknesses. Currently, however, we see only limited pockets of credit risk and vulnerability to higher rates.
• ? Conversely, there is scope for a credit‐fuelled boost to consumption. G7 household borrowing relative to its trend is arguably close to 40‐year lows, so unless financial deepening has reached a limit, there is scope for increases in borrowing. Furthermore, G7 bank deleveraging could be over, boosting credit supply conditions.
• ? We see two positive longer‐term drivers of the global consumption share: (i) Asian economies will become more consumption‐driven; (ii) Household re‐leveraging offers scope for some debt‐fuelled consumption growth. Offsetting negatives are that demographics, interest rates and asset prices will provide little support

     

BoE financing of the government deficit is no longer taboo

• ▪ The BoE has hinted that it could directly finance the government's soaring deficit. While there is no urgency to do so at present, BoE purchases could calm potential disruption in the gilt market and be a strong economic support.
• ▪ Direct money financing by the UK central bank would be a radical approach, but not unprecedented. However, it's necessary to go back to 1914 to find the last episode when the BoE took on the role of funding public borrowing.
• ▪ Once normality returns, money financing could result in a rise in prices. But a time-limited expedient shouldn't result in persistent inflation. And policymakers could seek to unwind the BoE's money creation.

     

Five ways the pandemic could alter the economy

• ▀ Economic crises are often turning points, and the upheaval triggered by coronavirus may prove one of them. A permanently bigger state and public borrowing, persistently cowed consumers, a more ‘national’ UK economy and the impetus for beneficial reforms are all possibilities.
• ▀ We think the scale of state intervention in the economy to protect public health will increase pressure to do more in aid of other social goals. The austere ‘Treasury view’ of deficits is also likely to wane.
• ▀ Meanwhile, evidence suggests that major economic shocks can exert a decades-long drag on consumers’ desire to spend, giving another reason why higher government borrowing may persist long after the pandemic has faded.
• ▀ Supply-chain vulnerabilities exposed by the virus may crystallise the more ‘UK-first’ approach to economic policy that Brexit ushered in. Although greater protectionism could threaten economic dynamism, the crisis could be the stimulus to structural reform, offering a potential growth upside

     

Government sets 2021 marker for EU trade deal

• ▀ We expect the UK and EU to agree an FTA that will take effect on 1 January 2021, two years earlier than we had previously assumed. The earlier introduction of trade barriers will dampen the post-coronavirus recovery.
• ▀ The economic case for delaying the implementation seemed to have been strengthened by the pandemic, which has left firms and the government ill-equipped to adapt. But political considerations have won out.
• ▀ We think a basic trade deal is more likely than not. The terms of the withdrawal agreement mean that failure to agree an FTA would increase frictions on trade between GB and NI. The UK will also be keen to protect vulnerable sectors.

     

Alternative policy options for combatting a downturn

• ? With limited scope for conventional monetary policy options, central banks and governments may need to turn to alternative approaches to combat slowing global growth and respond to economic shocks.
• ? Our analysis shows that not only do governments in advanced economies have limited room to cut rates but that doing so has proved less effective in boosting growth in recent years. This increases the need to look at alternatives, such as negative interest rates, renewed QE and fiscal stimulus.
• ? While negative interest rates have helped reduce borrowing costs in some economies, the impact on banks has been ambiguous. Also, lowering rates further into negative territory could be hard without incurring significant costs.
• ? QE in the form practised up to now is also likely to be less effective than in the past due to low yields, narrow risk spreads and high asset valuations. So, a deeper downturn might require more radical QE ‐ buying corporate bonds, bank loans and equities ‐ which comes with significant drawbacks.
• ? Some central bankers are starting to acknowledge the limits of monetary action, with the next step being to consider fiscal action as a more effective alternative ‐ as argued recently by the likes of Larry Summers.
• ? In our view, fiscal policy is likely to be especially effective in a climate of weak growth and low rates, with large multiplier effects. Advanced economies have more scope for fiscal stimulus than often recognised and could finance a large public investment programme by issuing ultra‐cheap long‐dated debt

     

World Economic Prospects

Overview: Global deflation – a genuine risk?

• The notable decline in inflation in the Eurozone, US and UK since mid-2013 has led to suggestions that a period of widespread price deflation across the major economies is a risk. Adding to these concerns has been the trajectory of producer prices – already declining in the Eurozone and China and showing very subdued growth elsewhere.
• Our global GDP forecasts do not, in isolation, point to a worldwide deflation risk. We expect growth at 2.8% this year and 3.2% next, little changed from last month.
• But the starting point for this growth matters, specifically the gap between actual and potential output last year. Even with reasonable growth, an initially large output gap would imply downward pressure on inflation over the next two years.
• Unfortunately, the size of the output gap is very uncertain. There is a wide range of estimates for the major economies, especially Japan. Part of the problem is that it is hard to know how much potential output was (or was not) permanently lost during the global financial crisis and recession.
• Assuming substantial permanent losses, output gaps might be relatively modest now, but a more optimistic view of the supply side of the economy would suggest output gaps could be quite large – and arguably this fits better with the recent evidence from inflation.
• Overall, while we see a genuine risk of deflation in the Eurozone (with around a 15% probability) we are more upbeat about the other major economies, where growth in the broad money supply and nominal GDP do not seem to be signaling deflation risks.
• But the difficulty of measuring ‘slack’ in the economy for us underlines the case for central banks to err on the side of caution when setting monetary policy, and either not tightening too soon or easing further. This month we have built in a further ECB rate cut to our Eurozone forecast. In Japan, we have revised down growth for 2014–15 with recent data strengthening the case for additional monetary easing this year.

     

Government bond yields will remain stuck to the floor

• ▀ The fallout from the pandemic will cement the trend of safe haven bond yields remaining low over the next five years. Any rises will be gradual and limited. We project bond yields will struggle to get much above end-2019 levels by 2024.
• ▀ Despite record issuance by US, UK, German, and Japanese governments, the rise in private sector savings and demand from central banks will keep the flows of demand and supply for safe assets in broad balance. Overall, the world will still suffer a chronic shortage of safe assets, keeping yields depressed.
• ▀ Weak prospects for nominal GDP growth, demographics, and rising inequality in the aftermath of the pandemic all point to low yields. This would also be consistent with historical experience following pandemics.

     

Central bank hawks unlikely to gain the ascendancy

• ? Although further financial market weakness could delay or scale back central bank tightening this year, the waters are being muddied by the perception that underlying inflation pressures are building and that past exceptional measures to counter downside risks may no longer be needed. On balance, we think that it is more likely that central banks will push back, rather than bring forward, rate hikes, especially if the recent oil price weakness persists.
• ? The most crucial issues for the path of monetary policy are likely to be the outlook for inflation and the risks to growth prospects. While there may be grounds to reverse past ‘insurance’ cuts in interest rates, only a slow pace of normalisation is justified at present, in our view. In Europe in particular, sustained lowflation remains a risk.
• ? Central banks may develop a taste for raising rates if they perceive the neutral interest rate to be trending up. There may also be a desire to normalise policy to create space for future loosening, but this will only affect policy at the margin. Meanwhile, although problems such as banking troubles and the zombification of firms are often blamed on low interest rates, they are probably more a symptom of low growth and other more structural issues. Raising interest rates is unlikely to resolve these problems.
• ? At the margin, central bank behaviour may become less dovish. However, with the global economy slowing and some recession warning indicators flashing amber, the wings of the hawks will likely remain clipped.

     

Why ‘King dollar’ is reigning supreme

• ▀ After a pause in late 2017 and early 2018, the dollar has resumed its rise. Our analysis suggests the long-term factors influencing the dollar are likely to remain supportive in 2020, ebbing only in 2021.
• ▀ Alongside positive interest rate differentials, several key factors explain the recent dollar strength including relatively strong economic growth, a contained external deficit and significant equity market outperformance.
• ▀ Over 2018–2019 US growth has been faster than the rest of the G7, which suffered more downside surprises this year. Meanwhile, the deterioration in the US external deficit was less than expected, despite the Trump fiscal stimulus.
• ▀ The massive improvement in the US oil balance over recent years looks like an important long-term structural support for the dollar. It allows the US to grow faster and have a stronger currency than would otherwise have been the case.
• ▀ The dollar is also supported by its still-dominant position in global financial markets. Recent talk of ‘de-dollarisation’ looks to be largely hype - the dollar's share of cross-border transactions, trade invoicing, and FX reserves is high and either stable or rising.
• ▀ The conditions necessary to create another dollar bear market like that in 2002–2008 may be hard to reproduce. A period of relative underperformance in US stocks is conceivable, but the 2002–2008 period also featured large US basic balance of payments deficits and persistently negative long-term real yield differentials, which look less likely to materialise.

     

The Macroeconomic Effects of Shocks to Large Banks’ Capital

We propose a simple approach to quantifying the macroeconomic effects of shocks to large banks’ leverage. We first estimate a standard dynamic model of leverage targeting at the bank level and use it to derive an aggregate measure of the economic capital buffer of large US bank holding corporations. We then evaluate the response of key macro variables to a shock to this aggregate bank capital buffer using standard monetary VAR models. We find that shocks to the capital of large US banks explain a substantial share of the variance of credit to firms and real activity.     

Fed Credit Policy: What is a Lender of Last Resort?

Discussions of the Fed׳s financial crisis lending – and its role as “Lender of Last Resort” more generally – often overlook the distinction between monetary policy and credit policy. Central bank actions constitute monetary policy if they alter the quantity of the bank׳s monetary liabilities, but constitute credit policy if they alter the composition of the bank׳s portfolio without affecting the outstanding amount of monetary liabilities. In the 19th century, Henry Thornton and Walter Bagehot advocated Lender of Last Resort policies as a means of expanding the money supply when the demand for money surged in a crisis. In contrast, the Fed׳s recent crisis lending for the most part left its outstanding monetary liabilities unaffected, and thus represented credit policy, not Lender of Last Resort activity. Credit allocation in a crisis is potentially costly because it affects market participants׳ beliefs about the likelihood of future central bank rescues, which in turn reduces their incentive to protect themselves against financial distress and thus exacerbates financial instability. Credible limits on credit policy thus are critical to central banks׳ core policy mission. One path to establishing such limits is to create “living wills” that detail how to resolve large, complex financial firms without government support.     

Trade credit versus bank credit: Evidence from corporate inventory financing

In this study, I introduce capital market imperfections into a structure framework of inventory investments and investigate impacts of trade credit on firms’ inventory dynamics and analyze the relationship between trade credit and bank loans. As a result, firms end up using a mix of trade credit and bank loans. I find that the use of trade credit and bank credit can be either complements or substitutes. During tight monetary periods, trade credit operates mainly as a substitute for bank borrowing while during looser monetary episodes even when the economy is weak, trade credit and bank loans are dominated by a complementary effect.     

MONETARY TRANSMISSION MECHANISM IN CENTRAL AND EASTERN EUROPE: SURVEYING THE SURVEYABLE

Abstract.  This paper surveys recent advances in empirical studies of the monetary transmission mechanism, with special attention to Central and Eastern Europe (CEE). Our results indicate that the strength of the exchange rate pass-through substantially declined over time mainly due to a fall in inflation rates and to some extent due to the so-called composition effect. The asset price channel is weak and is likely to remain weak because of shallow stock and private bond markets and because of low stock and bond holdings of domestic households. House prices may become an exception with booming mortgage lending and with high owner occupancy ratios. While the credit channel could be a powerful channel of monetary transmission – as new funds raised on capital markets are close to zero in CEE – it is actually not, as both commercial banks and non-financial corporations can escape domestic monetary conditions by borrowing from their foreign mother companies. The moderately good news, however, is that those banks and firms are influenced by monetary policy in the euro area because their parent institutions are themselves subjected to the credit channel in the euro area.     

Interbank credit and the money manufacturing process: a systemic perspective on financial stability

Interbank lending and borrowing occur when financial institutions seek to settle and refinance their mutual positions over time and circumstances. This interactive process involves money creation at the aggregate level. Coordination mismatch on interbank credit may trigger systemic crises. This happened when, since summer 2007, interbank credit coordination did not longer work smoothly across financial institutions, eventually requiring exceptional monetary policies by central banks, and guarantee and bailout interventions by governments. Our article develops an interacting heterogeneous agent-based model of interbank credit coordination under minimal institutions. First, we explore the link between interbank credit coordination and the money generation process. Contrary to received wisdom, interbank credit has the capacity to remove the inner limits of monetary system capacitance. Second, we develop simulation analysis on imperfect interbank credit coordination, studying impact of interbank dynamics on financial stability and resilience at individual and aggregate levels. Systemically destabilizing forces prove to be related to the working of the banking system over time, especially interbank coordination conditions and circumstances.