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Magazine Extracts – Central Banks adapting to new situations
Macro

Magazine Extracts – Central Banks adapting to new situations

The biggest challenge facing the Fed in the coming months (and years) is to sketch a roadmap for closing the floodgates of liquidity.
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15 SEPT, 2020

By Constanza Ramos

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The real challenge facing the FED and ECB

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Covid-19 is supplying the catalyst for a secular change in the role of central banks. With public-sector balance sheets under enormous pressure, the overriding goal is to provide governments with ammunition to fight the virus. And that means keeping bond yields pinned close to, or below, zero for the foreseeable future. Public sector balance sheets weren’t in great shape coming into the coronavirus crisis, and they’re soon going to look an awful lot worse. At the end of last year, the combined government debt of the G7* group of large industrial nations stood at almost 120% of gross domestic product (GDP). That’s higher than at the end of either the first or second world wars. This year, with budget deficits soaring, this number is likely to rise to something like 140% of GDP.

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There was a time —and it’s not that long ago— when these debt ratios would have been considered unsustainable. But with central banks helping to hold interest rates close to zero, that’s not the case today. But just how low do interest rates need to be for the major developed economies to remain solvent? To explore this point, we calculated debt-stabilizing interest rates (DSIRs) for a number of countries. This shows the average cost of funding needed to keep the debt-to-GDP ratio stable and it’s driven by three variables: the level of debt itself, the size of the primary budget balance (excluding interest payments) and projected nominal GDP growth.

How the market reacted

Notably missing from the Fed’s minutes was any mention of ‘yield curve control’ – a tool which would effectively put a cap on treasury yields. At WisdomTree, our assessment of the impact of Fed’s policy on asset markets is as follows:

A continuation of existing tools of monetary accommodation is a dovish stance from the central bank. We do not expect the Fed to employ additional unconventional tools of accommodation at this stage.

Mobeen Tahir

Fed’s real challenge

The biggest challenge facing the Fed in the coming months (and years) is to sketch a roadmap for closing the floodgates of liquidity. At this point in time it might seem like a ‘nice problem to have’. But given long and variable lags between policy implementation and impact on the economy, these are issues the Fed needs to be thinking about now. And despite the reliance of asset markets on monetary accommodation as a propellant, the Fed will need to tighten policy as unemployment falls and inflation rises closer to the Fed’s desired 2% target.

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