Unprecedented monetary and fiscal policy support across the world has allowed financial markets to look through a remarkable amount of bad news over the past year. Asset prices made their lows for the cycle in March, around the time that Europe and the US started to impose restrictions on economic activities, and long before we had visibility on the end of the pandemic crisis. With vaccines now in the process of being rolled out globally, there is light at the end of the tunnel and we can think about a world where activities can resume with fewer restrictions or concerns. This leads to a number of important questions regarding how and when the support programmes put in place can start to be unwound.
The timing of the withdrawal of policy support should be dependent on the speed at which the virus and economic situation improves. The case for linking fiscal policy support to the virus is compelling, as it directly impacts the measures taken to control the virus and helps support household and businesses most affected. With the virus situation still a concerning, the need for continued fiscal support for the economy is apparent. Discussions are in progress in the US around the level and design of another package, whereas furlough schemes are being extended in Europe. With vaccine approvals and distribution infrastructure being ramped up significantly in the coming months, the primary risk is that virus mutations reduce vaccine efficacy, so this is something to monitor closely.
On the other hand, the link between monetary support and the virus is more tenuous as central bank tools do not influence health and economic outcomes quite so directly. Even so, against this backdrop it does seem odd to worry about monetary policy, but concerns among market commentators have recently risen around a potential “taper tantrum” event. Higher bond yields after the Georgia run-off elections and some of the recent commentary from Federal Reserve officials have raised the prospect of a strong recovery in the second half of the year requiring some clarification around the potential timing of reducing central bank asset purchases.
Back in 2013, then Fed Chair Bernanke explained at a congressional testimony that “if we see continued improvement and we have confidence that that’s going to be sustained, then we could in the next few meetings … take a step down in our pace of (asset) purchases.” The subsequent market gyrations remain relatively fresh in the memory: 10 year treasury yields climbed from 1.6% to 3%, Emerging Market equities fell 16% and Emerging Market local currency debt fell 11%.
However, there are important differences between now and 2013. At the time there was a lot of uncertainty around how an exit from Quantitative Easing would work, what “normalisation” might look like, and growth in China was decelerating. Critics at the time said that stimulus could never be unwound, so there was pressure to demonstrate that this was not the case. Furthermore, this time around there is a new framework in place which involves targeting average inflation and essentially elevates the goal of getting to full employment.
One of the arguments in favour of the Fed starting to telegraph the withdrawal of central bank stimulus is that the two main transmission mechanisms for monetary policy (housing and financial conditions) are both strong. With signs of excessive risk-taking in financial markets (elevated retail activity and frothy sentiment,) it may be tempting to remove policy support to counter these risks to financial stability.
However, monetary policy is a notoriously blunt tool and macro prudential policies are favoured to increase the resilience of the system and allow greater focus on their specific objectives. Bernanke summed up this trade-off in a 2015 blog post: “to the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.”
With all this in mind, the Fed is well aware of the sensitivity around this issue and, with the recovery still fragile, is unlikely to want to tackle this challenge until we see more evidence that the virus is under control and the economic recovery is sustainable. When asked at the recent press conference, Fed Chair Powell was unequivocal: “The whole focus on exit is premature…it’s too soon to be worried about that.”
While monetary policy here doesn’t necessarily impact the economy directly, easy monetary policy can help influence the economy by enabling and encouraging fiscal support. With around 10 million jobs lost in the US since the pandemic began, the Fed’s focus is firmly on doing all it can to help get people back to work. Investors should expect an on-again/off-again debate about policy normalisation later this year, but for now the progress and success of the vaccine roll out is much more important for markets.
Nicholas Rilley, CFA, is Invest Manager and Strategy Analyst for Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.