Monetary policy during these challenging Covid-19 crisis times
High levels of leverage make companies more vulnerable
The Covid-19 outbreak has put an enormous pressure on central banks to come up with a plan to save the global economy. While their focus is mainly on the same tools used in 2008, there are calls to revisit traditional monetary policies in light of the changed economic environment.
At the start of the year, the world was carefully watching Donald Trump’s impeachment trial and Harry and Meghan stepping back from the Royal Family. Many of us considered the Covid-19 outbreak in China to be far removed from our own personal lives. Several months later, we are being inundated by red-lettered news. The global lockdown resulted in a sharp increase in unemployment rates. At the same time, the volatility of many asset classes and currencies spiked, which led to a forced sell-off. And while many corporates just published their plummeting Q1-figures during the so called ‘earnings-season’, investors are already fearing a second wave of infections.
Higher levels of leverage
In an attempt to head off an economic crisis, many central banks are flooding the economy with cash, using the same toolkit as in 2008. First, they reserved trillions of firepower that will be used to purchase government and private sector bonds, as well as commercial paper. Second, several of them, for instance the Fed, carried out interest rate emergency cuts to encourage borrowing and investing. However, many economists note that today’s economic environment cannot be compared to the one in 2008.
Thanks to the large body of post-crisis regulation, the financial system is in much better shape in 2020 than it was 12 years prior. Banks are forced to both hold more high-quality liquid assets and fund their activities with more stable sources of cash. The Achilles’ heel of today’s economy is mainly located in the private sector, where we have seen historically high levels of leverage as a result of the low interest rate environment created by the central banks. It is key for these highly indebted companies to safeguard cash flows that are both high and stable enough to service their debt. It therefore goes without saying that high levels of leverage make companies more vulnerable and less able to absorb this shock. Being in an environment where revenues are collapsing and where future cash flows are highly unpredictable can and will be disastrous for many.
Revisiting central banks’ independence
The specific role of the central banks in this crisis is still subject to many discussions. Supporters of Modern Monetary Theory (MMT) say that the focus of monetary policy should shift from targeting inflation towards controlling the unemployment rates, as economists expect the latter to surge towards a level comparable to the 1930s Great Depression. Others argue that central banks should set up a plan to effectively bail out individual companies, even though many criticized this approach after the 2008 crisis. One thing is sure, the current tools of the central banks are becoming less effective. The rock-bottom interest rates, along with the inflated balance sheet of central banks, leave little room for additional interest rate cuts or for another round of quantitative easing.
More than ever, it is time to temporarily ease the concept of central banks’ independence and aspire a joint effort between governments and central banks. According to an OECD study , most governments focus on tax deferrals and the introduction or expansion of short-time work schemes to support business cash flow. When failing to align this fiscal policy with the monetary policy of central banks, we face the risk that continued public expenditures will result in increasing yields on government debt, thereby making it more expensive for sovereigns to raise debt. To prevent this from happening, we need governments and central banks to come up with an integrated approach that supports the private sector while keeping both interest rates and inflation under control.
So, what’s next?
The extent to which monetary and fiscal policies will help corporations and households weather this pandemic remains to be seen. Whereas banks were the center of the storm in 2008, it looks like the real economy is now most at risk. Traditional monetary policies will need to be redefined to cushion the economic impact of the pandemic. However, a recession seems inevitable as many highly indebted companies are barely keeping their head above water. To borrow some words from business tycoon Warren Buffet: “It’s only when the tide goes out that you discover who’s been swimming naked.”
Please contact Bruno Lamoral if you have any questions or remarks on monetary policy during these challenging Covid-19 crisis times.