What’s next in the policy revolution?

We have witnessed nothing short of a revolution in macroeconomic policy in recent months. Jean shares his take on what to focus on next.

Macroeconomic policy has gone through a needed revolution to cushion the coronavirus shock. It essentially aims to “go direct” and is blurring fiscal and monetary policies. Yet this policy shift has opened the door to unprecedented government intervention in markets and companies, and we see it as a slippery slope – unless it comes with proper guardrails and a clear exit strategy.

The scale and speed of the policy response has been greater than at any moment in peacetime history, fundamentally transforming the core tenets of global policy frameworks and financial markets. We view the economic impact and policy response as two key signposts for gauging the virus shock and compare our assessment of the lost national income across major economies with policy measures announced to date. The orange bars show the full-year hit to GDP from our sector-level bottom-up analysis, including the initial impact on the most affected sectors (such as travel and leisure) and the broader impact on the whole economy due to spillover effects (light orange). The fiscal response more than covers the initial impact in the U.S. Once we factor in the spillover to the full economy, the fiscal policy response (dark yellow) globally falls short. Yet the situation improves when monetary policies (light yellow) are accounted for. This is especially striking in the U.S., as the chart shows.

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Major economies may still struggle to entirely bridge the gap left by the plunge in demand, income and cash flow, despite the unprecedented policy measures, in our view. We see a risk of policy fatigue leading to an exit or a retrenchment too soon, especially in the U.S. The U.S. labor market unexpectedly improved in May, showing signs that policy interventions were cushioning the blow from the shock – and highlighting the risk that policymakers may give up on relief measures sooner than necessary.

The uncharted territory that policymakers have entered makes policy execution particularly important. The new policies explicitly attempt to “go direct” – bypassing financial sector transmission and delivering liquidity to individuals and businesses. Another aspect of this policy revolution is the explicit blurring of fiscal and monetary policies, including central banks absorbing new government debt to maintain low bond yields. In addition, some government support comes with strings attached, including conditions around dividend payouts and share buybacks.

We wrote about the necessity for monetary and fiscal coordination to deal with the next downturn last August. Effective coordination would reduce lost output in a major shock, and could lessen other risks, such as rising inequality, that were seen as arising from the unbalanced policy response to the financial crisis. We warned it needed proper guardrails and a clear exit strategy to mitigate a risk of uncontrolled deficit spending with commensurate monetary expansion and, ultimately, inflation. One approach we laid out is a Standing Emergency Financing Facility (SEFF), a framework in which the exit from the joint monetary-fiscal policy effort is explicitly determined by the inflation outlook. To be credible, this exit decision must be independently controlled by the central bank. And even a well-designed monetary strategy may not prevent a change toward a higher inflation regime in the medium term because of deglobalization and re-regulation trends.

The bottom line

The policy revolution is a near-term positive for markets but, in the absence of guardrails, might not be in the medium term. One key investment implication is the reduced ballast properties of nominal government bonds over a strategic horizon, as interest rates are near or at their effective lower bounds and we see greater inflation risks in coming years. We think increased strategic allocations to inflation-linked bonds are sensible amid this shifting balance of risk.

Jean Boivin, PhD, is Head of the BlackRock Investment Institute. He is a regular contributor to The Blog.

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