Negative territory effects

Negative territory effects

The spread of coronavirus across the globe, affecting more than 170,000 people and counting, isolating communities and claiming lives, has already had a major impact on international markets and economies. 

But probably more than in previous global challenges – market meltdowns, tsunamis or terrorist attacks – Covid-19 is, in hard macro-economic terms, infecting both supply and demand dynamics. Further, the onset of a supply war in oil has rocked markets already in a rout.

This time it may do little to ease major headwinds to global growth, ramping up the pressure on global central banks charged with managing the fallout across multiple fronts.

From central banks’ perspective, the spread of coronavirus provides another argument for keeping policy rates close to the floor, and the ‘punch bowl’ of central bank liquidity filled.

In driving both negative demand and supply shocks, the virus threatens at the very least an unanticipated hit to first-half year activity – whether or not China is able to fully reflect this in its data. Of course, multiple factors beyond finance are currently impacting the knock-on effects of the outbreak. 

But, for major economies, the combination of lower demand and ruptured supply chains will drive inflation, regardless of which comes first.

Yet inflation led by shortages, rather than being driven by demand, is the ‘wrong sort’ for central banks’ typical 2 per cent targets.

Adverse aggregate supply shocks reduce output and increase inflation, adding to the risk of stagflation for an economy.

In these scenarios, central banks turn on the taps and extend easy money – as we have seen in past weeks with the US Federal Reserve, Bank of England, and Reserve Bank of Australia’s emergency rate cuts.

And this at a time when Japan and much of continental Europe are in negative interest rate territory.

That said, with little room now to manoeuvre without low or negative rates becoming well-entrenched, central banks’ more limited ammunition will hopefully force governments to turn to fiscal tools — tax cuts and capital injections — as they work to offset the supply and demand hit.

What central banks can do is provide further temporary relief to markets.

In this respect, we can expect more of the same: central banks continuing to flood the economy through quantitative easing, further inflating asset prices already distorted by a decade of cheap money and a $15tn (£12tn) sink of QE.

The bulk of this (almost $10tn) has amassed since the end of the last US recession.

This effective liquidity injection to the private sector is equivalent to almost one-half of US GDP, three-quarters of China’s, or three times the UK’s.

Yet, it may now be proving a problem, not the solution.

Prompt policy action is of course needed during this difficult time. Yet, by prolonging cheap money, the background risks of QE’s unintended consequences will continue to rise. 

While early QE unclogged the global economy pipes, by providing liquidity and keeping yields down, it also loosened the monetary reins when interest rates were already on the floor.