Western governments’ policy during the pandemic has been to prevent monetary conditions from tightening as a result of the fiscal response to the virus. I suspect it will remain that way. That is, for as long as our elected representatives seek to stave off any civil unrest, they will deem it necessary to use fiscal instruments to protect the population from the worst of its financial impact. For this to work, it is right that the central banks continue to control the yield curve and I suspect they will.
At the European Central Bank (ECB), for example, various communications have been clear that if more stimulus is needed, the ECB will buy up the sovereign debt issued once it has circled through the markets. Indeed, they have been able to slow their purchases under the Pandemic Emergency Purchase Programme (PEPP) which they announced in March to cover both private and public sector securities in an attempt to stabilise the monetary policy transmission mechanism in response to the negative forecast for the Eurozone due to COVID-19. They have executed this without compromising their yield curve control objective, with some commentators suggesting the slowing allows scope for a further EUR 600 billion by year end with perhaps another EUR 500 billion which could be added when they meet in December.
As long as the debt sits on central banks’ balance sheets, it will be cost-free for governments and taxpayers. But of course it is not as easy as that; there must be some downsides. Will it be inflationary? When central banks stop reinvesting in securities, and even starts to sell them, what will be the impact on budgets of the cost of debt?
I have written about the inflationary point before. As illustrated by the huge expansion in private savings in recent months, we are suffering a demand apathy and not a supply restriction, and so the fiscal expansion is simply propping up demand to fill the gap. Accordingly, the printing of money to cover the public sector deficit is not inflationary provided households and businesses don’t spend it, and given the lockdowns there is no immediate prospect of that changing.
As regards the second question on reversal of the measures and a reduction in balance sheets, it is hard to predict. Its timing cannot be predicted as it will depend on economic conditions. But when a central bank eventually needs to cool an overheating economy it will use whatever tools and process it deems appropriate to maximise the smoothness of the impacts of intervention and minimise financial instability. This will most likely involve raising interest rates before employing balance sheet tightening.
The task will be easier to orchestrate in a situation where the economy’s productive factors have not been severely scarred and thus potential output lowered significantly. So the various responses to the pandemic look responsible and could continue to be added to without significant concern. Indeed this new approach to national fiscal policy combined with monetary policy is likely to become the norm and represents the best course of action for the good of society and the avoidance of a depression from which it could otherwise take a generation to emerge.