Fiscal and Monetary Together

Fiscal and Monetary Together
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Fiscal and Monetary Together

It was the day of coordinated policy moves in the UK, as both the Bank of England (BoE) and the government announced significant measures to counter the economic effects of the coronavirus. The synchronisation aims to amplify the impact of the actions taken, with the BoE helping credit flow to companies and freeing up fiscal space (via lower interest rates), and the Treasury announcing targeted virus-related measures to help households and small businesses. After a decade in which central banks cut rates to record lows, while most European governments kept tight fiscal policies, the ongoing global disruption now warrants a more coordinated approach.

In its first unscheduled move since the 2007-08 financial crisis, the BoE cut its policy rate by 50 basis points (bps) to +0.25%, following similar moves by the U.S. Federal Reserve (Fed) and Bank of Canada last week. The European Central Bank (ECB), meanwhile, is expected to announce easing measures tomorrow. While rate cuts will not stop the spread of the virus, the point is to ease financial conditions, bolster confidence and give some respite to companies and the government by lowering their financing costs. To make the effects of the cut felt more directly in the real economy, the Bank of England also launched a new Term Funding Scheme (TFS). The TFS includes additional incentives for small and medium-size enterprises (SMEs) – which may be more vulnerable to the negative economic effects of the virus. The BoE also reduced the bank’s countercyclical capital buffer to 0%, releasing an equivalent of additional £190 billion of bank lending capacity on our measures.

Fiscal

Fiscal policy was equally bold, with Chancellor Rishi Sunak announcing a wave of new easing measures. While some actions were directly targeted to soften the impact of the virus outbreak, including a statutory sick pay leave, most of the boost will come from higher investment spending, allocated over the next few years. The fiscal boost is back-loaded: most easing is set to take place in the next fiscal year, while the easing in 2020/21 looks modest in size.

If the macroeconomic situation worsens, the government may add more front-loaded stimulus in coming quarters.

The government expects a headline deficit of 2.4% of Gross Domestic Product (GDP) in 2020 – though the true deficit will likely be closer to 3% once the impact of the virus on the economy is fully taken into account. While stressing the temporary effects of the disease on the UK economy, the Chancellor also acknowledged the government’s long-term plan to address Britain’s structural weaknesses in the distribution of wealth – a move coined as “levelling-up” in his party’s election pledge. Despite this promise, the government signaled it would stick to its fiscal rules for now -- but also noted that these rules may be reviewed.

Outlook

The outlook is highly uncertain and depends crucially on the speed and extent of the virus spreading, and what measures the government puts in place to curb it. However, we believe that in the UK, as in other developed countries, the coordinated fiscal and monetary policy response is unlikely to meaningfully limit the deceleration in activity ahead. The worst for the economy may be still to come, and there is a distinct possibility that the UK falls into a technical recession in the coming quarters. Still, today’s measures will likely soften the fall, prevent the shock from creating lasting damage to the supply side of the economy, and may lead to a more pronounced post-virus recovery in activity. Similar to our outlook for global growth, we expect UK activity to follow a U-shaped trajectory over the next few quarters.

Preparing for such scenario, the BoE was explicit that it will “take all further necessary steps to support the UK economy and financial system.” If economic activity worsens, we expect the central bank to cut its policy rate again, this time to +0.1%, at its next meeting on March 26. At this stage, negative policy rates seem highly unlikely in Britain; if additional easing is needed, further asset purchases (Quantitative Easing) will most likely feature next, as there are no binding limits on further QE, nor does the BoE impose any rules on itself.

While we believe that growth should rebound after the outbreak abates, the ongoing health crisis and subsequent global market sell-off is another stark reminder that secular disruptors and uncertainty are playing an increasing role in financial markets.

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