Jean Dalbard, economist at Agence France Trésor and BSI Economics, answers three questions about monetary policy during the COVID-19 crisis.
BSI Economics – Can we expect a resurgence of inflation after the coronavirus crisis?
Jean Dalbard – In the post-health crisis world, there are two opposing views on the outlook for inflation. For some, the major fiscal stimulus plans and significant monetary support from the major central banks, as well as certain structural trends, such as a potential shortening of global value chains, could have an inflationary effect in the medium term. Others believe that the impact of the crisis on demand (rising unemployment, falling commodity prices, deleveraging by households and businesses) will be so profound and lasting that inflation is unlikely to pose a serious risk for several years. While the ambitious measures taken by fiscal and monetary authorities are entirely justified and appropriate given the scale of the shock facing our economies, it is certainly too early to have a definitive opinion on what inflation will look like after the health crisis. In this context, the first indications provided by the market or central banks as to the medium-term direction of inflation suggest that it is indeed the risk of (very) low inflation that is to be feared. In Europe, for example, the 10-year inflation swap is hovering around 0.85%, while the 5-year inflation swap in 5 years, historically observed by the ECB, is trading at levels slightly above 1%, far from the Eurosystem’s target (i.e., a level « close to but below 2% in the medium term »). These and other indicators suggest that market participants are anticipating very moderate inflation in the medium term, with demand factors outweighing supply factors, while analyses of monetary base growth as a risk factor for price stability still do not seem to be reflected in the market.
Is rate normalization conceivable after the economic crisis?
Central banks made full use of their monetary margins during the crisis, significantly reducing their key rates, relaunching QE and introducing dedicated facilities in the US, or relying on a mix of ambitious measures in the eurozone (targeted refinancing operations, intervention programs, changes to the collateral framework). Furthermore, the use of negative interest rate policy (NIRP), although sometimes heavily criticized, is continuing or expanding, as evidenced by forward rate expectations in the UK, the US, and New Zealand. Coupled with aggressive refinancing operations such as TLTRO 3, which introduces a quasi-policy rate of -1%, i.e., a dual policy rate system, this negative interest rate policy reinforces monetary easing in the face of the pandemic and anchors rates at low levels.
These measures are thus helping to maintain the low interest rate environment and limit the risk of a steepening yield curve by compressing the two components of long-term interest rates (short-term rate expectations and the term premium). The lasting impact of the crisis on the one hand, and the de facto extension of central banks’ forward guidance on the other, should thus maintain this downward pressure on rates for a long period. More broadly, this fear of monetary policy normalization or interest rate hikes actually requires us to question our understanding of what is normal in terms of rates. The historic and ongoing decline in the global neutral interest rate (« r star ») could thus be amplified by the health crisis, as shown by the work of Jorda et al. (2020), which forecasts a potential 120 bp decline in this neutral rate post-pandemic. At the very least, this global neutral rate could remain within a very low range compared to pre-crisis expectations. In short, the normalization of rates seems an unlikely risk at present.
Have the measures to reduce US interest rates in response to the crisis been effective?
The Federal Reserve once again reacted very quickly and convincingly to the financial crisis linked to the health crisis. It mobilized a set of particularly relevant measures: a very significant cut in its key rates to 0%, a relaunch of its quantitative easing (QE) program, leading to an increase in the Fed’s balance sheet to levels above USD 7 trillion, and the implementation of various targeted facilities under its extraordinary powers in times of crisis (Article 13, Section 3 of its bylaws). All of these measures adequately address the various issues facing the Fed.
At first glance, the Federal Reserve’s objective was to maintain sufficiently accommodative financial conditions so as not to penalize the financing of the US economy. The cut in key interest rates and the establishment of currency swap lines with other central banks supported financial conditions and limited dollar financing risks. The relaunch of QE was intended to limit the extreme volatility observed in the US Treasury market during the peak of the crisis. US government debt is indeed a safe haven asset par excellence, whose liquidity allows investors in search of cash – for example, to finance a margin call – to easily liquidate their positions in order to meet this need. The « quasi-money » nature of US debt therefore played a definite pro-cyclical role, to which the relaunch of QE responded perfectly, limiting volatility through daily purchases sometimes exceeding USD 70 billion. Finally, the various facilities (for money market funds, the corporate debt market, market makers, etc.) helped to limit defaults in certain market segments, illustrating the increasing complexity of monetary policy tools and their relationship with macroprudential policies. As a result, they facilitate the smooth functioning of the market and thus keep rates low. In short, the Federal Reserve’s response was instrumental in reducing volatility and interest rates during the crisis, responding both massively and precisely to market contingencies.
