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Central bank watcher: The great repression

Central bank watcher: The great repression

19-10-2020 | Insight

Monetary authorities are likely to continue repressing sovereign borrowing costs well below the nominal rate of economic growth, for years to come. The era of great financial repression may have only just begun.

  • Bob Stoutjesdijk
    Bob
    Stoutjesdijk
    Analyst
  • Martin van Vliet
    Martin
    van Vliet
    Strategist and member of Robeco’s Global Macro team, Robeco
  • Rikkert  Scholten
    Rikkert
    Scholten
    Portfolio Manager

Speed read

  • Federal Reserve will avoid painting itself into a corner
  • The ECB is tiptoeing towards another QE top-up
  • People’s Bank of China swims against the flow

As the second virus wave across Europe is rising, in turn prompting renewed (partial) lockdowns, expectations are mounting that the ECB will be soon forced to deliver further easing. This should ensure that the additional fiscal support needed to bridge companies and households through the second wave does not translate into higher borrowing costs for (some) Eurozone member states. Looking further ahead, we suspect monetary authorities, both the ECB and many other central banks, will continue to repress sovereign borrowing costs well below the nominal rate of economic growth for years to come – so as to prevent primary budget deficits from leading to even higher public debt-to-GDP ratios. The era of great financial repression may indeed have only just begun!

The adoption of a 2% average inflation target should aid the US Federal Reserve’s financial repression efforts. In China, where nominal GDP growth is improving amid a seemingly controlled virus situation, the central bank has completely dropped its earlier easing bias. However, we suspect that sustaining private sector credit growth may require a further decline in official lending rates. Hence, we second-guess the market’s expectation for the PBoC to continue to swim against the (global monetary) flow.

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The Fed's official message unchanged, but some signs of unease

The message from the Fed has been pretty consistent: the virus trajectory will determine the pace of the recovery, this is a disinflationary shock, it will take years before unemployment is back at the February level and we will allow a moderate overshoot of inflation before even considering hiking rates. The recent FOMC minutes revealed that this is a widely shared belief. But still. There are a couple of clues, which suggest that Fed officials are not that keen on painting themselves in a corner where rates remain at zero forever. An important clue comes from the minutes of the September FOMC meeting, which revealed that several members were concerned that their current guidance on policy “could limit the Committee's flexibility for years” and lead to a “buildup of financial imbalances”. Another clue came from the 14 October speech by Fed Vice Chair Richard Clarida, where he distinguished current economic conditions from 2008, foreseeing “a relatively rapid return to mandate-consistent levels of employment and inflation as compared with the recovery from the global financial crisis”.

Approaching the elections

Whether or not there will be an agreement on additional fiscal stimulus ahead of the elections will be important for the potential impact on rates of the 3 November elections. If a deal would be reached, the impact of the election result on rates will probably be modest. The more likely scenario is no deal before the election. This implies uncertainty will prevail for now. Uncertainty on fiscal negotiations as well as on the acceptance of the election result. To be clear, a contested election is the main risk to fiscal stimulus shorter term, as stimulus talks will come to a complete standstill in such an environment. For nearly all outcomes we do expect meaningful stimulus, albeit with some delay. The only outcome in which we don’t expect much stimulus is a Trump victory and a Democratic Congress.

For the ECB, further top-up of QE draws closer

While ECB president Lagarde acknowledged at the September news conference that the ECB was closely monitoring the appreciation of the euro exchange rate, and continued “to stand ready to adjust all of its instruments”, she shied away from hinting strongly at imminent action. Moreover, although the forward guidance that rates could end up at “lower levels” was maintained, Lagarde seemed to (again) put more emphasis on PEPP. However, the recently released minutes from the September meeting serve as a strong reminder that, given the subdued inflation outlook, the ECB retains an easing bias and that all instruments are on the table.

In our view, the growing risk of a persistent inflation target undershoot will likely prompt the ECB to deliver further easing before the turn of the year.

In China, a far less dovish central bank

Rhetoric from the PBoC has turned increasingly less dovish over the past few months. It seems authorities are progressively less concerned about the economic outlook, and content with the improvement in the closely watched credit ‘impulse’. Our economic barometer for China confirms that the recovery has continued apace. However, consumer spending, while also steadily improving, still lags production growth. Moreover, the recent decision to scrap the bank’s reserve requirement ratio for FX derivate sales (from the current 20%) – to stem the appreciation of the CNY – is an indication that the PBoC does not want financial conditions to tighten (much) further.

New captain for Japan Inc.

The Suga administration took office on 16 September with a higher approval ratio (74%; Nikkei) than the second Abe administration had at its start. Suga announced that he will move forward with Abe’s policy stance, but that regulatory reform is the core of this administration’s policy. While we agree on the merits of such a focus, we expect little and only slow progress over time, given Japan’s structural struggles in this area. Japan’s economy has long faced the challenge of how to conquer population aging and decline in order to raise productivity growth and potential growth. The Covid-19 outbreak highlighted that the adoption of digitalization has been slow and that many face-to-face industries like the service sector have to change their business models to adjust to the new.

Overall, we don’t see a material difference between the policies of Abe and Suga, nor in the implications for the overall economy and the BoJ. In that sense, the BoJ’s current role of fiscal financier to the government is unlikely to change.

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