The COVID-19 pandemic has exacerbated previously existing tensions. Income inequalities, geopolitical discrepancies between the great powers and a separation of the financial markets from the real economy, due to the interventions of the central banks, became even more apparent. The result is a paradigm shift in monetary policy that could last in the long term. This is the opinion of Aidan Yao, Senior Emerging Asia Economist and Jim Veneau, Head of Asian Fixed Income at AXA Investment Managers.
Central bank actions are easier to start than stop
In the midst of the pandemic, central banks have taken unprecedented steps to protect the global economy from collapse and an even wider recession. “Your actions have led to a paradigm shift in monetary policy,” says Yao. This can be seen in the rapid expansion of central bank balance sheets, which now contain a wider range of assets and thereby monetize the budget deficits. With this approach, governments can use liquidity injections in a targeted manner. “We also saw bold market intervention that allows central banks not only to set the price of money, but also to influence the value of loans, stocks and other high-risk assets,” said Veneau. The central banks saw the measures as a necessary reaction to the economic shock. Closing the liquidity tap could, however, prove to be more difficult than opening it for several reasons:
First, despite the recent improvement in sequential growth, the global economy continues to move on thin ice. Most economies are unlikely to return to their pre-crisis levels until late in 2021. In addition, even this forecast is based on the assessment that the corona virus is only a one-time shock, given the resurgence of the number of infections in the USA and the challenges of containment in emerging countries such as Brazil, Mexico, Russia, South Africa and India might prove too optimistic.
Second, the inflation outlook is bleak. “Even if inflation should make a comeback, the US Federal Reserve (Fed) has already signaled its willingness to tolerate price increases above the midpoint of its target corridor after falling short of the target for so long. As a result, in the absence of sustained inflation, central banks could struggle to justify a move away from their current policies, ”said Veneau.
Third, a dramatic rise in indebtedness resulting from the strong stimulus should paradoxically limit an interest rate hike. Developed countries’ debt ratios could rise to 200 or even 300 percent of gross domestic product, and private sector indebtedness will rise significantly from the emergency loans that companies have carried through the tough times. Even a small increase in interest rates with this level of debt could endanger the fragile recovery of the global economy.
No central bank will want to be responsible for causing the market to collapse. Given how much liquidity has contributed to a long-running bull market, especially since the beginning of quantitative easing, it is hard to imagine that prices would not go down significantly as liquidity was withdrawn. And since central banks are now one of the biggest owners of many high-risk assets, every action they take must also keep an eye on the potential damage to their balance sheets.
“We are of the opinion that the very loose monetary policy is now firmly anchored. In addition, if the current economic stimulus is not enough to keep the economy alive, key interest rates could not only be kept low for the foreseeable future, but other more innovative instruments could also be introduced – such as buying riskier assets, checking the yield curve or negative interest rates “, Says Yao. Interest rates of zero or near-zero could become the global standard for the foreseeable future.
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