William De Vijlder

Following the judgment of the German Constitutional Court on 5 May, the ECB Governing Council needs to demonstrate that the monetary policy objectives of its PSPP are not disproportionate to the economic and fiscal policy effects resulting from the programme. In most cases, monetary, economic and fiscal policies are mutually reinforcing. When assessing whether monetary policy is appropriate, one should take into account the stance of economic and fiscal policy. The necessity to have adequate transmission to all jurisdictions as well as the likelihood and extent of tail risks due to insufficient policy action also play a role in the assessment.

Major central banks have stepped up their efforts to attenuate the economic impact of the pandemic, raising the question whether there is a limit to balance sheet expansion. An asset purchase program (QE) can continue for a long time, given the possibility to broaden the investable universe. Quite likely, asset price distortions and concern about the riskiness of the central bank balance sheet will act as the true constraint. For this reason, a central bank could decide to finance the budget deficit directly, considering that this should have a bigger growth impact for a given expansion of the balance sheet. The real challenge under such a strategy is to keep inflation under control once the output gap is closing.

Clear progress has been made at the European Council meeting this week. The proposals of the recent Eurogroup meeting on the creation of three safety nets have been endorsed. There is agreement to work on a recovery fund intended for the most affected sectors and geographical areas in Europe. Its financing would be linked with the multiannual financial framework. Importantly, Chancellor Merkel has declared that, in the spirit of solidarity, one should be prepared to temporarily pay a higher contribution to the European budget.

The Eurogroup has reached an agreement on bringing EUR 500 bn -4.2% of eurozone GDP- of additional firepower to attenuate the immediate economic impact of the Covid-19 pandemic. Three tools will be used: the SURE programme to temporarily support national safety nets, the EIB guaranteeing lending to companies -in particular SMEs- and a Pandemic Crisis Support via the ESM. The work on the creation of a Recovery Fund to boost European investments will continue. The difficult part will be to agree on its funding.

Recent activity and demand data for China show the huge impact of the coronavirus epidemic. German business expectations have seen an unprecedented monthly drop in March . The drop in the price of oil acts as an additional drag on growth and a source of increased credit risk. The strengthening of the dollar is a source of concern for issuers with foreign currency debt in dollar. Despite swift action of the major central banks and the announcement of increasingly important fiscal policy support in various countries, equity markets have barely reacted: lack of visibility dominates.

Wall Street has entered a bear market, having declined more than 20% from its high. Equity markets globally have seen huge declines this week and corporate bond spreads have widened significantly.Despite the positive news from China, the combination of an uninterrupted international propagation of the coronavirus has dealt a blow to expectations about the growth outlook for the next several months. The oil shock has made matters worse.Central banks have reacted. After the Fed rate cut last week, the Bank of England cut rates as well and the ECB also took several measures to support activity.The instrument of choice at the present juncture is fiscal stimulus of a sufficient size. Both in the US and the eurozone, we are still waiting for this impulse.

The Federal Reserve created a surprise this week by, quite unusually, going for an inter-meeting cut of the federal funds rate of 50 basis points. At first glance, the very nature of an epidemic makes monetary policy ill-equipped to address the consequences. The drop in demand and the disruption of supply are not related to the level of interest rates. Nevertheless, monetary policy has an important role to play in the current environment by seeking to avoid a deterioration of the financial and monetary conditions. This is a defensive move, the alternative being to run the risk that the tightening of these conditions acts as an additional brake on activity. It seems this has played a role in the decision of the FOMC and it now puts the onus on the ECB to act at its meeting next week.

As part of the Federal Reserve’s strategy review, the introduction of a target range for inflation is being discussed. Such a range could provide flexibility in the conduct of monetary policy. It could also take into account past shortfalls in inflation. Introducing a range when inflation is below target runs the risk of being perceived as not being bothered by the inflation shortfall. This would call for an asymmetric range but this increases the risk of market turbulence when a tightening cycle starts.