After a somewhat underwhelming G-7 statement promising cooperation but not much more, the Federal Reserve moved quickly (as discussed by my colleague John Bellows) in an emergency meeting to cut the target range for the fed funds rate by 50 bps. While this increased the likelihood of other major central banks easing their respective policy stances, so far there has been no “emergency-style” follow-up elsewhere. This mainly highlights that emergencies do lie in the eye of the beholder, but also that other central banks might be more constrained in their reaction functions. To be clear: we think there is a large number of central banks that are likely to cut rates sooner rather than later, including many in emerging markets. To the extent that the economic shock stemming from COVID-19 is perceived as at least partly a demand shock, an easing of the monetary stance can be considered appropriate, and a Fed rate cut has more often than not led to cuts elsewhere.
That said, so far the Fed sticks out for acting off-schedule, and there is a fair chance that major European central banks may wait for their scheduled meetings. In Europe, the European Central Bank (ECB) meets on 12 March, and the Bank of England (BoE) meets on 26 March. Both are likely to announce policy measures at those meetings—or earlier in the case of the BoE. Similarly, Norges Bank and the Swiss National Bank meet on 19 March, whereas in Sweden the Riksbank’s next meeting is scheduled for late April.
Assuming for a second that European central banks also view the shock of the virus as something they should react to—which is likely, including for public relations purposes—we think the BoE is more likely than the ECB to cut policy rates, simply because it is in a better place to do so. For the ECB, the threshold to cut rates is higher for two reasons: First, deposit rates are already in negative territory. Second, it will take a very elaborate communication effort to unwind the “emergency cut” at a future point in time without sending the market into a frenzy. We expect the ECB to look mainly at the indirect impact of the slowing economic activity and work to ensure appropriate liquidity in the banking system and on corporate balance sheets. In other words, we think there is a higher likelihood of some sort of liquidity provision rather than a rate cut. Put differently, it is difficult to imagine a rate cut that comes without additional measures geared at liquidity management. If the ECB were to cut its deposit rate by 10 bps—in line with market pricing—we would expect several other European central banks to follow: the Swiss National Bank, the BoE, and some of the central banks in Northern and Central Europe. For Sweden, on the other hand, the situation is a bit trickier: The next regular meeting is far away, and a rate cut would mean going back to negative rates after having just closed that chapter of monetary policy history.
We think that the focus of the European response will be on fiscal policy. We have seen Italy already prepare two stimuli, worth around 0.3% of its GDP. If adopted, we think these efforts will have a high growth multiplier and be quite effective. In addition, at the European level, there is likely to be a coordinated effort culminating in the Summit in late March that could see a small but joint fiscal effort. Two other countries we are watching in this context are the UK and Germany. In the UK, the budget is due on 11 March. Given the political winds, this budget was already going to be expansionary anyway, and the economic fallout from the virus provides a convenient cover to be even more expansionary. In Germany, we note that there is a lot of talk about the fiscal space created by previous surpluses. We think one likely way of supporting the economy quickly would be by advancing a tax cut pencilled in for January 2021. As this is a tax cut geared at low-to-middle income earners, it is also likely to be quite stimulative.
To sum up, we don’t think Europe or the eurozone will go into recession as a whole, but some parts may. Eurozone growth for the 4Q19 was confirmed at +0.1% relative to 3Q19. This makes it unlikely, in our view, that the eurozone will go into recession from what we know now about the COVID-19 impact because it would imply that not only 1Q20 would have to show negative growth but also 2Q20. This is obviously possible, but it would require a serious deterioration of the situation for several months, even after the effect of policy reaction is taken into account. On the other hand, France and Italy shrank in 4Q19, and the likelihood of a technical recession in those countries is quite high.