The Big Question: What Tools Do Central Banks Have At Their Disposal During The Next Recession?

Five fund groups tell Investment Week what policy tools Mark Carney, Jerome Powell and Christine Lagarde will have to use should there be a global downturn. Photos: Chris J Ratcliffe/PA Wire/Liu Jie/Xinhua News Agency/Thomas Padilla/Maxppp/PA Images

Isobel Lee, head of global fixed income bonds at Insight Investment

Change to policy frameworks 

Major central banks have already experimented with unconventional policies to varying degrees and we would expect to see these policies used again in the future. 

However, with interest rates still at such low levels, a global recession could see policymakers turning to new options. 

Central bank policy frameworks could be changed, with average inflation targeting or price level targeting possibly adopted as a response to the persistent undershooting of inflation targets post-Global Financial Crisis.

More radical policies could see central banks and governments co-ordinate, monetising fiscal spending to boost growth. The debate around this could potentially be a focus during the 2020 US presidential debate, depending on the choice of Democratic Party candidate. 

We view the European Central Bank (ECB) and the Bank of Japan (BoJ)as being close to exhausting existing policy options, making it difficult for either central bank to meaningfully counter a global downturn.

David Zahn, head of European fixed income at Franklin Templeton Investments

Fiscal easing

Central banks globally have their usual tools to combat the next economic downturn, including cutting interest rates, asset purchases and forward guidance. These tools can still provide powerful stimulus to the economy. 

However, we must remember economies are at different points in this cycle. The ECB will be first to act aggressively as European growth is slowing, specifically in Germany.

I expect the ECB will cut interest rates to make the base rate more negative, introduce tiering to mitigate the impact on the banking system, but also signal that interest rates will be extremely low for a very long time and reintroduce quantitative easing. 

In addition, fiscal easing will also play an important role in combating a European slowdown, with increased government spending probably focused on the energy transition of the economy and central bank purchases providing attractive financing for the bonds.  

The Monetary Policy Committee in the UK will probably keep policy on hold until the impact of Brexit is determined, but then will also be on an easing path.

Edward Park, deputy chief investment officer at Brooks Macdonald

Significant differences 

The primary drivers of our strategic preference for equities over bonds is the low-inflation backdrop that allows central banks globally to remain highly accommodative. 

That said, there are significant differences between the ability of the two major developed market banks, the ECB and the Federal Reserve, to deliver further stimulus. 

The Fed has reduced its balance sheet from around $4.5trn in late 2017 to around $3.75trn now. This, alongside the rate hikes that took place during this period of balance sheet normalisation, allows the central bank to react more decisively to shifts in the economic landscape. 

In the minutes released from the 25 July meeting, the ECB was at pains to emphasise that the central bank’s toolbox was not empty. 

However, in order to deliver the ‘bazooka’ this time round there will need to be changes to the bank’s self-imposed 33% issuer limit for buying member eurozone countries’ sovereign debt, as well as requiring possible changes to the capital key that governs the ratio of member countries’ debt that can be bought. 

All of this means that while the ECB and Fed both have capacity to ease policy, the political hurdles to the Fed acting are far lower.

Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers

Money financed fiscal stimulus 

As the global growth slowdown continues, questions remain regarding how much additional support central banks can provide as both nominal and real yields fall further into negative territory, especially in the eurozone. 

Interestingly, at the recent Jackson Hole conference, a number of prominent central bank representatives also questioned the effectiveness of monetary policy easing in offsetting the damage from rising uncertainty on global trade policy. 

In terms of the tools available, we think a money financed fiscal stimulus – whereby government spending is financed by the central bank rather than debt issuance – can be a powerful source of stimulus and can trigger both a surge in growth and inflation. 

That said, the application of such a policy would require solid credibility and due care when it comes to the time lag between an announcement and implementation. 

Various studies show that a poorly designed and communicated money-financed fiscal easing can worsen the growth slowdown and lead to unstable inflationary dynamics. 

John Vail, chief global strategist at Nikko Asset Management 

Rate cuts 

Despite an increasingly gloomy global outlook, central banks do have some tools at their disposal to help combat a recession. 

For example, the Fed can cut rates to zero and the ECB and BoJ can cut rates a bit more, though the latter is increasingly facing political and international constraints. 

Negative rates, however, on retail deposits are  far from impossible. In addition, the Fed could buy corporate bonds, following the ECB’s lead, or equities, following the BoJ’s lead. 

And, as central banks act as financial regulators as well as monetary policymakers, they can encourage banks to lend more and loosen standards for borrowers. 

That said, the market knows central banks cannot prevent recessions forever. Aggressive policies always have some longer-term negative side-effects, including increasing wealth inequality and contributing to unaffordable housing. 

Charges of currency manipulation and competitive devaluations are now reaching the mainstream and gold prices are surging despite economic weakness, implying a loss of confidence in currencies, which worries risk takers. 

Moreover, 2% CPI targets set central banks up for failure, which decreases investor and business confidence in the economy.