The Bank of England and Fed have scope to double QE programs…
Central banks have welcomed the news about a recent COVID-19 vaccine breakthrough. However, implementation risks remain on vaccines, and a more flexible policy armory may still be required because monetary policy initiatives, since the COVID-19 crisis, have closely followed the GFC playbook. Policymakers have eschewed direct, money-financed, fiscal stimulus, or “helicopter money” (HM), involving direct purchase of central government debt. Instead, central banks have either expanded purchases of government and corporate bonds in the secondary market, or broadened corporate loan programs. Chart 1 shows both the Fed and Bank of England still have modest balance sheets, as a percentage of GDP, compared to the ECB and BoJ.
G7 fiscal stimulus appears substantial, but these deficits are magnified as a percentage of GDP by the collapse in GDP, which the IMF forecasts to be about three times the scale of the GFC economic contraction, at -4.9% in 2020, as Chart 2 shows.
…but using GFC playbook in a liquidity trap may have little impact, as BoJ found
Even if the Fed and BoE switched to bigger balance sheet expansions, the risk remains that the GFC playbook may not deliver the required increase in aggregate demand and economic recovery. Japan’s experience suggests once deflationary expectations are entrenched, a liquidity trap can soon follow. Hence, despite negative interest rates and the BoJ’s balance sheet reaching over 140% of GDP (shown in Chart 1), neither inflation nor inflation expectations have recovered to near the 2% target, as the 7-10yr inflation breakeven levels show in Chart 3.
Evidence on the efficacy of negative interest rates is also mixed
Nor is it easy to see why negative nominal rates would deliver a sustained recovery, when the current deflation is not caused by high nominal interest rates, but a public health emergency. In theory, negative deposit rates reduce the incentive to hold cash in bank accounts, and should drive increased spending, but they may squeeze banks and financial systems, and returns for pension schemes.
Furthermore, if the demand for savings is exceptionally strong, making policy rates negative is unlikely to boost spending more than marginally. They may also hit confidence, and encourage wholesale withdrawals of deposits from banking systems, like Northern Rock in 2007.
Finally, by holding policy rates below the true marginal cost of capital, negative rates increase the risk of “zombifying economies” by supporting loss-making companies, and subordinating monetary policy to the task of propping up financial markets. It then becomes difficult to normalize interest rates without increasing deflation risks, so once policy rates become negative, they may remain negative for an extended period (i.e., the ECB & BoJ).
COVID-19-bond financed stimulus, is unlimited in size and not temporary
This suggests permanent support for aggregate demand may be needed from direct, money-financed, fiscal stimulus (HM). Since this is potentially unlimited in size, and therefore able to secure recovery, it has been argued that avoiding this form of stimulus is a clear policy choice . It could be supported by strong governance from central banks on the use of the central government’s account at the central bank, and subject to inflation targets not being breached .
…it could be permanent, reduce debt costs and the threat of future austerity
Such fiscal stimulus would be distinct from the current stimulus and QE, which is not designed as a permanent increase in money supply, or in debt issuance, but carries the deflationary threat of future austerity (Ricardian equivalence). It could be achieved by issuing perpetual COVID-19 bonds, carrying a zero, or near zero coupon, to be purchased by the national central bank. This would be quite different from the UK’s War Loan, since War Loan raised UK finance from the private sector for the first world war, and was not money-financed by the BoE. It also carried what now seems a high coupon (of 3.5% from 1932-2015). The coupon is also irrelevant anyway if central government is effectively paying the coupon to itself, via the central bank. Given that a 50-year gilt currently yields about 0.8%, the interest savings on a £300 billion perpetual would be about £2.4 billion per annum with a zero coupon, with those interest savings boosted further by the positive multiplier effects on GDP growth, employment and tax revenues. Ironically, the Eurozone, which was the last major economy to adopt QE programs, has come closest to going down this route, by agreeing the issue of a mutualized COVID-19 bond, though there is no proposal as yet, that the ECB finance it by printing money.
 See “Ultra-low or negative interest rates: what they mean for financial stability and growth,” Herve Hannoun, BIS, April 2015. “Wicksell’s natural rate”, R. Anderson, St Louis Fed Short Essays, 2005.
 “The simple analytics of helicopter money, Why it works, Always,” W. Buiter, Kiel Institute Discussion Paper, No 2014-24.
 See FTSE Russell blog, April 2020.
 War Loan was issued in 1917, to help pay for the UK’s WW1 expenditures, and redeemed in 2015.
Originally Posted on November 19, 2020 – Getting Negative About Negative Interest Rates?
Disclosure: FTSE Russell
This material is not intended as investment advice. Interactive Advisors or portfolio managers on its marketplace may hold long or short positions in the companies mentioned through stocks, options or other securities.
© 2020 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®“ and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided “as is” without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of the FTSE Russell products, including but not limited to indexes, data and analytics or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained herein or accessible through FTSE Russell products, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB, BR and/or their respective licensors.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from FTSE Russell and is being posted with permission from FTSE Russell. The views expressed in this material are solely those of the author and/or FTSE Russell and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.