Monetary policy is dependent on fiscal policy

Monetary and fiscal policy: Tango always takes two

[Capital market news from October 29, 2020]

Conclusion: With PEPP, the ECB is implementing an ambitious purchase program that gives fiscal policy room for maneuver. Nevertheless, further monetary policy measures are expected due to the second wave of infections. A likely adjustment of the macro forecast in December and the ECB's emphasis on downside risks reinforce this view.

What is crucial, however, is that fiscal policy becomes more active. Without an expansive fiscal policy, the current monetary policy is like a string that one tries to push. Expectations should also be directed towards the euro countries. Only they can prevent an escalating wave of bankruptcies in 2021. The ECB has always created the framework for effective action.

Economy and monetary policy overshadowed by the second lockdown

A second wave of corona infections has broken through Europe and is increasingly pushing political measures that are strongly reminiscent of the first half of 2020. Countries such as Spain, Italy, France and Ireland therefore run the risk of again seeing a significant decline in GDP in the fourth quarter. This risk also exists for Germany. Nevertheless, the manufacturing sector should support the German economy in the fourth quarter due to robust demand from the Asian countries. Nevertheless, after positive developments in the third quarter, the economic outlook for the euro zone has deteriorated significantly again. Although new macro forecasts will not be published until December, the ECB also stressed a clear downside risk to the European economic outlook in its most recent meeting.

It is true that the revisions of the expected GDP growth figures due to the second lockdown may turn out to be rather manageable. However, the risk of increasing bankruptcies and the associated rising unemployment should not be underestimated. After all, it is the duration rather than the depth of a recession that determines business failure. Whatever the further development, the recovery in the euro zone should be a lot flatter than was expected just a few months ago. As a result, the pre-crisis level of GDP is a long way off and credit risk premiums will continue to rise - which the ECB cannot prevent in the short term.

Persistent overcapacities, weak domestic demand, a lack of fundamental confidence in the economy and rising unemployment will counteract possible price pressure for some time to come. It is true that the costs of production processes may rise in the future as a result of decreasing global specialization. However, this is only likely to be reflected in greater price pressure if there is an effective increase in demand. It seems that the ECB has only a slim chance of achieving its inflation target on a sustainable basis in the years to come. This is also shown by the latest inflation forecasts by the ECB. She expects an inflation rate of only 1.3% in 2022.

Effectiveness of monetary policy reduced to supporting fiscal policy

Even after the financial crisis in 2008 and 2009, it was often argued that the ECB's set of monetary policy instruments was exhausted. In fact, since then the ECB has always been in a position to play a “monetary policy shovel”. In June 2014, 0% interest turned into negative interest, while money market interventions turned into conditional purchase programs, which now have ever larger dimensions and fewer and fewer conditionalities. And the ECB still sees room for more - even after six years with negative interest rates. Without a doubt, a policy of effective liquidity generation helps to largely prevent a crisis of confidence. How effective a sustained crisis policy is, however, is less clear.

There should be little doubt that tightening current monetary policy would have negative real economic consequences. The current monetary policy does not provide significant positive impulses; But it also prevents clear negative effects and is therefore anything but ineffective. This is especially true of their influence on fiscal policy. Because of the lockdowns that have been adopted and the lack of trust, the effectiveness of monetary policy is largely limited to its impact on fiscal room for maneuver.

Persistently low and negative interest rates have secured or expanded the room for maneuver of the euro countries. The ECB never tires of emphasizing that it is the turn of fiscal policy to take on its responsibility for economic stability. However, this also means that the debt sustainability of many euro countries largely depends on the ECB, which will limit the European central bank's room for maneuver for years to come. However, the Fed, the Bank of England and the Japanese central bank are now playing a similar role.

Due to the ongoing corona crisis, states are being forced to expand their debt ratios more and more. The same applies to many companies. Since it takes several years of high economic growth to lower these ratios again or to create a lower dependency of debt sustainability on the interest rate level, monetary policy itself has no leeway in the medium to long term. A rising inflation rate would not necessarily change this. Ultimately, inflation would have to prove sustainable in order to force a monetary policy reaction. However, given the rate of inflation over the past 20 years, slightly higher inflation may not necessarily be in conflict with the ECB's mandate. However, it remains to be seen what results will emerge from the review of the ECB's monetary policy strategy and whether it will adjust its mandate if necessary.

Today's Session - Implications for Markets

Specific announcements such as a further interest rate cut were hardly to be expected due to the current implementation of the ECB measures - especially the PEPP and APP purchase programs. New macro forecasts in December should better capture the extent of the new lockdown on the economy and identify possible need for action for the ECB. Nevertheless, the ECB also emphasized the high current economic risks in its meeting today. President Lagarde emphasized that monetary policy will be recalibrated on the basis of new forecasts and, if necessary, adjusted in December. Expectations of further measures in December were thus maintained, also because it can be assumed that the ECB's growth forecasts presented in September 2020 will be revised downwards. However, a revision of the growth assumptions for the fourth quarter of 2020 as a result of the second lockdown would have little monetary policy significance - unless the second lockdown also weighs on growth in the euro zone in the medium term.

The effectiveness and scope of monetary policy are discussed again and again. The ECB remains true to its line of recognizing both interest rate cuts and purchase programs have a measurable impact on inflation and growth. President Lagarde also reiterated at today's meeting that the monetary policy toolbox is anything but empty. Another interest rate cut, further TLTROs and an expansion of the purchase programs remain possible options for monetary policy and are part of the recalibration in December. However, as expected, the ECB has not been carried away to make a specific statement regarding an instrument. However, President Lagarde again emphasized the need for an effective fiscal policy to combat the corona crisis.

The ECB's renewed willingness to act has basically confirmed the expectations of the financial markets, but risk aversion continues to dominate with regard to the expected economic development. In principle, Bund yields received further support with today's meeting. This is less the case for credit risk premiums. The monetary policy influence of the ECB on the real economy is limited, while the economic outlook is clouding again. Therefore, a further or renewed increase in credit risk premiums can be assumed - despite the ECB's efforts. The latest developments suggest a weaker euro. The ECB cannot allow monetary policy tightening through an appreciating euro. The explicit emphasis on the exchange rate as a factor of uncertainty confirms this assessment.