Central banks go all out

The European Central Bank (ECB) and its US counterpart, the Federal Reserve (Fed), have decided on various expansionary monetary policy measures and launched new asset purchase programmes. In doing so, they are trying to limit the economic impact of the coronavirus pandemic. An assessment of the central banks’ measures:

Action from the Fed

Recognising that coronavirus is causing severe disruptions in the US economy, the Fed decided on new measures to shore up the financial markets on Monday. These include theoretically unlimited quantitative easing (QE) along with extensive support to ensure the flow of credit to the real economy. At an extraordinary meeting, the Fed had already decided on a relatively aggressive interest-rate cut and the expansion of its bond-buying programme. It has since signed off additional targeted measures designed to maintain the supply of liquidity in the financial markets and for companies. The Fed’s decisions included:

  • Fed funds rate lowered by 100 basis points to a range of zero to 0.25 per Cent

  • Unlimited purchases of US government bonds and mortgage-backed securities (MBSs) from government issuers, in the amounts needed to “support smooth market functioning and effective transmission of monetary policy”. The Fed will also buy commercial mortgage-backed securities.

  • Launch of two credit facilities to provide market liquidity for corporate bonds (the Primary Market Corporate Credit Facility for new investment-grade issues and the Secondary Market Corporate Credit Facility for outstanding investment-grade bonds)

  • Easing of lending conditions for commercial banks (e.g. temporary easing of the capital requirements, longer loan Terms)

  • Establishment of a Main Street Business Lending Program to support lending to small and medium-sized Enterprises

  • Provision of liquidity in US dollars through swap agreements with other central banks from 23 March

  • Launch of facilities to support the money market and lending to companies (Commercial Paper Lending Facility and Money Market Mutual Fund Liquidity Facility)

  • Primary Dealer Credit Facility (PDCF) for increasing liquidity in the asset classes in which the Fed cannot make purchases directly.

What do these decisions mean? By taking this action, the Fed has exhausted virtually all its options. It cannot do much more within its remit. For example, the Fed can only support the corporate credit market by establishing facilities that are guaranteed by the US Department of the Treasury. Currently, it is not permitted to buy securities that do not have a government guarantee. Unless the Fed Act is amended by lawmakers, there are barely any further steps that it can take to support US companies.

It remains to be seen whether the measures decided upon to support the real economy will provide any help in the current crisis. After the Fed’s most recent measures were announced, spreads narrowed in the US corporate bond market and yields on US government bonds fell. Price volatility continued in the stock markets.

The main aim of the Fed’s measures is to keep the credit channels open, as Fed Chair Jerome Powell emphasised. He explained that the Fed knew the virus would run its course and that the US economy would return to a normal level of activity afterwards. The pandemic was already creating a huge economic emergency in the US and across the world. In the meantime, the Fed would use the instruments at its disposal to maintain the flow of credit for the real economy.

Role of fiscal policy

In his statement, Powell also referred to the role of fiscal policy in stabilising sectors and companies that are in difficulty and in supporting workers affected by the crisis. He also praised the measures taken in the US so far. US President Donald Trump has already declared a national state of emergency. This move alone will release federal funding of up to US$ 50 billion to fight coronavirus at state level. At the start of the week, lawmakers were also working on a comprehensive fiscal package with a volume of up to US$ 2 trillion. This is a huge rescue plan and exceeds the support packages set up during the 2008 financial crisis.

ECB emergency measures to combat coronavirus

The ECB has also adopted a support package of historic proportions. Late on Wednesday evening (18 March), the European Central Bank (ECB) made the surprise announcement that it would increase its purchases of securities. An additional purchasing volume of €750 billion is planned under the new Pandemic Emergency Purchase Programme (PEPP). The ECB is taking this step to tackle the economic fallout of the coronavirus pandemic. The ECB Governing Council emphasised that it would do “everything necessary” and, if required, would adjust the size, duration and composition of the programme. It also said that it would explore all options to support the eurozone’s economy through the shock created by coronavirus.

Details of the steps decided upon:

  • €750 billion increase in bond purchases, both government and corporate bonds

  • All paper that is currently eligible for purchase will also be eligible under PEPP

  • Allocation of government bond purchases to be generally determined by the capital key, but with greater flexibility

  • Programme will continue for as long as needed, and in any case until the end of 2020

  • Relaxation of investment restrictions under the Corporate Sector Purchase Programme (CSPP) and expansion of the range of paper eligible for purchase

  • Easing of the collateral standards for commercial Banks

The ECB also explicitly emphasised its commitment to “playing its role in supporting all citizens of the euro area through this extremely challenging time”. It would therefore ensure that families, firms, banks and governments can benefit from supportive financing conditions that enable them to absorb this shock. If “self-imposed limits” were to run counter to achieving this objective, the ECB would consider revising them.

Substantial increase in support

This package of measures represents a substantial ramping up of its current efforts. Last week, ECB President Christine Lagarde significantly expanded the size and scope of the support that had previously been announced. Moreover, the central bank’s words underlined its determination even more clearly. This decision was clearly aimed at securing the trust and confidence of the public, governments and financial markets. The steps are therefore reminiscent of Mario Draghi’s “whatever it takes” promise, and not just in the choice of words.

We at Union Investment believe that the decisions and the emphasis on the ECB’s determination are the right approach. However, the resolution on PEPP is unlikely to bring a sustained period of calm to the capital markets. In our view, this would primarily require a significant worldwide slowdown in the number of infections. At the same time, though, we believe that both the real economy and the financial sector will benefit from it going forward. The decisions taken last week are therefore a key element in effectively tackling the economic fallout of coronavirus. Consequently, we continue to believe that the outlook for the capital markets is constructive in the medium to long term.

Summary

The central banks are now using the instruments available to them to take swift and far-reaching action in response to the current market turmoil. But to some extent, the central banks do not have ‘direct’ access to those parts of the real economy that are most affected by the coronavirus crisis. This remains a central challenge. The ECB is in a slightly better position in this regard and the new purchase programme should help to mitigate the disruption in the markets. From the Fed’s perspective, much will depend on whether the liquidity made available to banks will be passed on and thus help to counteract destructive second-round effects. But there will be no lasting turnaround in the equity markets until a marked slowdown in the number of new coronavirus infections manifests itself in key economies.

 

As at 23 March 2020