The consensus view on the economic impact of the Covid pandemic envisages a plunge in economic activity across the global economy in the second quarter of the year, followed by a recovery in the latter part of 2020, with no significant damage to potential growth. This may prove optimistic but also appears the prevalent view in equity markets, with investors ignoring data which does point to a very severe hit to output and employment, believing that short lived. Policy makers have reacted, of course, and we have seen a significant fiscal and monetary response, although that has varied across the globe and the contrast between the US and the Euro area (EA) in that regard is particularly striking.
On the monetary side the Fed initially reacted to a scramble for dollar liquidity by pumping trillions of dollars into markets that were effectively seizing up, including the provision of dollars to other central banks across the globe. It then embarked on a broad purchase of assets, ranging far beyond government bonds and mortgage backed securities, to include bank loans and even junk rated corporate bonds, taking the extraordinary step of buying the latter through ETF’s. As a reult the Fed’s balance sheet has grown by over 50% since the turn of the year, currently standing at $6.6 trillion from $4.2 trillion. As a result excess reserves held by commercial banks have doubled in just two months, to $3 trillion, while the money supply (M2) has grown at an annualised 16% pace over the past three months. Monetarists might worry about the implications for inflation down the line but markets certainly feel it is supportive of asset prices.
Monetary policy has also been supportive in the EA , but the scale of the response is quite different; the ECB’s balance shee has increased too but by only 12%, to €5.3 trillion from €4.7, and the amount of exces liquidity in the system has not greatly changed. It is also worth noting that interbank rates have actually risen (3-month euribor rose to -0.16% last week before falling back to -0.22%) implying that all EA banks are not deemed equal, while it is reported that US banks are pulling back their EA lending. Of course the ECB is constrained in its response relative to the Fed in that it can provide short and now longer term loans to banks but cannot buy unlimited amounts of assets, as its public sector purchases are contrained by the capital key and issuer limits. It has sought to circumvent the latter with its PEPP scheme, but that is limited to €750bn , at least for now.
On the fiscal side the EU has struggled to find a mechanism to provide support across member states, with the result that each county has sought its own solutions, although the degree of fiscal space available varies greatly. A €540bn package was produced to great fanfare by euro governments, but as with many such announcements the devil is in the detail- in this case €100bn was in the form of employment grants from the European Commission, with the rest in the form of EIB loans and ESM loans, with the latter unlikely to be taken up. Grants rather than loans became the big issue at the recent EU summit, with headlines emerging about a package amounting to ‘trillions’ but nothing was agreed and it seems that funds will eventually come out of the EU budget, with the issue of loans versus grants kicked down the road.
In the US the Federal fiscal response has been quicker and substantially larger, with a series of packages emerging, the largest being €2 trillion. Again one should note that some of this is in the form of loans, albeit guaranteed by the government on attractive terms. That said , the IMF expects the US fiscal deficit to exceed 15% of GDP this year, which is more than double that forecast for the EA. . In any downturn automatic stabilisers kick in ( tax receipts fall and government transfers rise) so fiscal deficits will increase anyway in the absence of any discretionary policy action but the difference between the respective US and EA deficits is clearly not just cyclical.