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Economic Research: Orderly Global Reflation Will Support The Recovery From COVID-19


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Economic Research: Orderly Global Reflation Will Support The Recovery From COVID-19

As vaccines are rolled out at an increasing pace, activity rebounds, and the light at the end of the COVID-19 crisis tunnel becomes brighter, thoughts have turned to the shape and speed of the recovery. Recently, discussions have focused on the risk of rapidly rising inflation.

Market fears that overaggressive fiscal policies could stoke a return of too high inflation have pushed bond yields higher and led central banks to clarify their (for now, dovish) reaction functions. In some ways, these discussions harken back to the days when the central bank's job was seen as taking away the punch bowl before the party got started (see appendix for details). In our view, these discussions confuse the risk of reflation fueled by a solid recovery, which is broadly positive, with the risk of a disorderly rise in inflation and yields, which is broadly negative. These fears are most pronounced in the U.S. but could spread as the recovery gains traction.

Our bottom line is that orderly reflation is, on balance, a healthy development for macro and credit outcomes. This narrative implies that moderate demand and wage pressures have reemerged after a lost decade and that the interest rate structure has the potential to return to more normal levels. While there will inevitably be some market adjustments as credit is repriced, this will lead to better outcomes.

Too Much Or Too Little Policy Response?

COVID-19 took an awful economic toll as governments imposed harsh restrictions on social mobility. These measures led to unprecedented declines in output and spikes in unemployment and much shorter working hours. Surprisingly to some, governments discovered that they had more fiscal space than thought and spending was accordingly ramped up to protect the hardest hit and to build the foundation for the recovery. And governments have continued to roll out large stimulus plans, in part to guard against the premature tightening that took place after the global financial crisis. Most notably, U.S. President Joe Biden's $1.9 trillion plan was enacted into law in early March 2021.

But how much is too much? Few economists would argue for a hyperaggressive, sustained fiscal stimulus that would run the economy too hot, push medium-term inflation expectations away from 2%, and require the Fed--or any central bank--to slam on the brakes and potentially put the economy back in recession. The flipside is the risk of going too little, driven by the 1970s-fear of stoking any inflation above target. This would keep fiscal policy too cautious and demand too weak, prolonging the period of ultralow rates and the negative effects on macro and credit outcomes.

Chart 1


Turning to the monetary policy response to the recovery, the issue is not whether it would be beneficial for central banks to move off zero. The answer is surely "yes." With the Fed's inflation target of 2% and estimates of the neutral real rate of interest around 0.5%, the neutral fed funds rate would be around 2.50%, consistent with the most recent Fed dot plot (see Related Research). With the Fed at 2.50%, the 10-year Treasury yield would be in the low- to mid-3% range. Interest rates on credit to private-sector firms would be on top of these rates, depending on the spread. This "neutral" rate structure would have several benefits: give the monetary authorities some ammunition for the next downturn, price credit in a way that would lead unviable firms to exit the market, and rationalize asset prices (see more below).

As we exit the COVID-19 downturn, monetary and fiscal policies would ideally be coordinated. In the case of fiscal policy, a middle path to create demand--and to withdraw it when no longer needed--would include aggressive near-term support that is withdrawn judiciously as private demand recovers, as we argued previously (see our latest outlook, "Global Economic Outlook: Limping Into A Brighter 2021"). This would help to anchor inflation expectations and support macro and financial stability. (For a "semiautonomous discretion" approach to fiscal stimulus, see the recent PIIE paper by Orszag, Rubin, and Stiglitz, link in Related Research.)

Rising Bond Yields Signpost A Normalization Of Credit Conditions

On the face of it, the recent rise in U.S. Treasury yields, and its spillover into corporate bond yields, could be a positive. It indicates greater confidence that vaccination programs and massive fiscal and monetary stimulus have created a path to a sustained recovery from the pandemic, and the start of a normalization in market functioning and risk pricing. Credit markets have traditionally performed well in the recovery phase of economic cycles as improving cash flow prospects and diminishing default rates outweigh rising financing costs.

This cycle, however, is likely to be very different from others. This is partly because of the nature of the COVID-19-led economic contraction, but also because of the unprecedented amount and types of stimulus applied to support economic activity--through stimulus checks, furlough schemes, and restrictions on insolvency proceedings. Credit spreads are near record lows, which is unusual for the depths of recession. The current situation is abnormal in many ways, and the exit path is potentially uncertain and volatile for credit markets, even if the broad direction is positive.

The impact of rising yields on ratings will depend on the timing and pace of market repricing. As the global economy recovers, a moderate reflation and increase in yields are to be expected. A rapid and volatile market repricing or durably elevated inflation--which we don't expect--would hurt, in particular, corporate entities at the lower end of the rating scale and in some emerging markets.

Some areas of focus from a credit perspective:

Risk premiums may need a reset.  Current accommodative market conditions and very low risk premiums are the result of the unprecedented monetary stimulus to ease the impact of the pandemic on market liquidity, in a context of economic hardship and high uncertainties. Exceptional measures major central banks have taken, including some targeted at the bond markets, have pushed corporate bond spreads down to below pre-COVID-19 levels, after peaking in March 2020 (see chart 2).

The global thirst for yield has benefited borrowers across the ratings spectrum, including nonfinancial corporate and emerging market issuers in the 'B' and 'CCC' rating categories. This is further depicted by the U.S. distress ratio--the proportion of speculative-grade issues with option-adjusted composite spreads of more than 1,000 basis points relative to U.S. Treasury yields--which declined to an 11-year low in February 2021. In contrast, we anticipate speculative-grade default rates to remain elevated through 2021 (at 6%-7%), after doubling in 2020.

Chart 2


Cost-push inflation may hurt profit margins.  Moderate inflation is generally positive because it supports normal earnings and improves debt sustainability measures. It also indicates confidence in the economic recovery, with a pickup in private demand and activity supporting creditworthiness. Higher rates would benefit banks' profitability and life insurers' or pension funds' reinvestment yields. However, downside risks could materialize if inflation affects disproportionally raw materials, commodity prices, and/or wages--culminating in potential declines in corporate profit margins.

Recoveries are not immune from challenges.  Working capital pressure arising from the need to rebuild inventories and address supply chain shortages and trade tensions--in addition to looming tax increases--are headwinds for corporate credit on the way to recovery and, as such, are potential triggers for market volatility.

A rapid market repricing pushing up debt costs would particularly hit highly leveraged entities in COVID-19-exposed industries, such as leisure and transportation.  The median debt-to-EBITDA ratio for COVID-19-affected industries increased to almost 5.5x at year-end 2020 from 4.5x at year-end 2019 (see chart 3). Reflecting this higher leverage and the difficulties on the path to recovery, 40% of speculative-grade corporate borrowers in the U.S. and 33% in Europe are now rated 'B-' and below. This suggests that default risks will likely remain elevated around 6%-7% through 2021.

On a positive note, corporate borrowers in the investment-grade category are less vulnerable to rising yields given the predominant fixed-rate borrowing that transpired. In addition, across the rating spectrum, approximately two-thirds of the debt issuance raised in 2020 was used to lower financing costs and extend maturities, with a good percentage of the debt proceeds being retained on balance sheets as cash (to bridge ongoing working capital deficiencies on the road to recovery).

Chart 3


Desynchronized growth may pose particular risks for some emerging market credits.  The U.S. $1.9 trillion fiscal stimulus package has placed the U.S. on a fast track, at a time when Europe confronts challenges in its vaccination program and emerging markets fall further behind, culminating in a desynchronized global recovery. This could particularly pose issues for some emerging markets, which have benefited from capital inflows from investors seeking yield alternatives.But the impact of rising rates on emerging markets will most likely happen selectively rather than across the board.

The recent rise in U.S. yields has so far resulted in relatively orderly adjustments and, as such, hasn't raised the alarms just yet. Volatility has modestly increased with hard-currency spreads remaining near recent lows. However, an accelerated or disorderly market repricing that pushes up medium- and long-term yields--and eventually the U.S. dollar--could weigh particularly on emerging markets at the lower end of the scale that heavily rely on foreign funding, and on those with large external or fiscal imbalances.

Higher debt costs could undermine sovereigns' debt stabilization efforts and, as a result, their credit quality.  Governments' responses to the COVID-19 pandemic have stepped up public spending to record highs, leading to a rapid increase in sovereign debt. S&P Global Ratings projects median general government debt for all 135 sovereigns we rate will rise by year-end 2021 to 62.6% of GDP, from 49.0% at the end of 2019 and 32.5% at year-end 2008. We expect that over two-thirds of developed and emerging sovereigns should manage to either stabilize debt to GDP or lower it by 2023, though from historically high levels (see "Sizing Sovereign Debt And The Great Fiscal Unwind," Feb. 2, 2021).

The main driver of debt stabilization is the adjustment to the size of fiscal deficits. We also expect that major central banks will keep policy rates at (effectively) zero until the recovery is well-entrenched and use some combination of asset purchase quantities, yield curve control, and credit easing measures to keep financial conditions loose. A return of interest rates to pre-COVID-19 levels wouldn't necessarily impede the stabilization of government debt, since many have been refinancing long-term debt at current rates with fixed coupons. Still, premature monetary tightening by major central banks leading to an interest rate shock could undermine debt-stabilization efforts.

Orderly Reflation Is Not To Be Feared

As we emerge from the first pandemic-driven economic and financial shock in over a century, it is important to distinguish desired outcomes from legitimate risks.

Reflation is one such outcome. An orderly lift in inflation and yields driven by a solid economic rebound from the COVID-19 shock is a good outcome on both the macro side and the credit side. This outcome will not only restore most of the losses from 2020, but it also holds the potential of ending over a decade of persistently too low inflation and extraordinarily low yields, with the attendant distortions.

The main risk to this desired outcome is that reflation happens too quickly or in an uneven manner. Spreads could jump and policy reactions could be disruptive. This would hurt corporate entities at the lower end of the rating scale and some emerging market economies on the macro side. But it's important to make clear that volatility and disorder around a reflation path is the risk, not reflation itself.

Appendix: A Short History Of Fighting Inflation And The Punch Bowl

The punch bowl metaphor dates back to 1955 and then Fed Chair William McChesney Martin Jr., who believed the role of the Fed was to take away the punch bowl just as the economic party was getting started as a precautionary move to curb excess inflation. Why? If the economy gets too far from its sustainable path, then the necessary adjustments to output and employment could be painful. (For the history of this metaphor, see Related Research.)

Developments in the 1970s confirmed this view. Then, inflation spiked--reflecting an overheating economy since the late 1960s, two oil price shocks, and negative wage-price dynamics. Central banks were initially behind the curve and needed to raise rates aggressively, leading to a wrenching adjustment.

These events had an impact on the economics profession. Many economists trained after the 1970s see the (sole) job of the monetary authorities as taking away the punch bowl just as the party is getting started, as McChesney Martin said. Governments have short-term political calculations and, therefore, an incentive to run the economy too hot--which creates an inflation bias. (The Taylor Rule for setting short-term policy rates prescribes that the monetary authority overcorrect for any deviation from the inflation target.) Independent monetary authorities are needed to ensure macro stability. This view was codified in the 1990s as many central banks, beginning with New Zealand and Canada, adopted inflation-targeting regimes.

The fear of inflation was largely one-sided. The idea that inflation might be too low for a protracted period was theoretically possible but remained a curiosity. Keeping the policy rate at zero for a long time or needing further easing by purchasing large amounts of assets was even more remote. Events in Japan, seen as an outlier, did little to alter this view. The effects of low rates--super-charging asset prices (including their role as collateral) with knock-on effects on inequality; encouraging investors to go out the credit curve (to search for yield); and lowering debt-servicing costs to keep zombie firms (that would otherwise not be able to meet those costs) afloat--got some attention but were rarely in the big debates.

Everything changed with the global financial crisis. After central banks cut rates quickly to zero as well as intervened in key markets to ensure liquidity and orderly trading, policy rates stayed at zero for longer than anyone expected. In addition, substantial quantitative easing was launched and stayed around longer than anyone expected. Even with these extraordinary measures, generating sustained low and stable inflation remained difficult.

Why? Secular stagnation had set it. Central banks spent most of the decade since the financial crisis as the only game in town, trying to stimulate demand. Without fiscal policy to help, this task was arduous. The Fed began to taper asset purchases in 2013 and lifted the policy rate from effective zero in 2016, reaching 2.50% in 2019. But that move toward normalization was short-lived, including because the neutral real rate of interest was lower than thought. The policy rate was quickly returned to zero in early 2020 as COVID-19 crippled the economy.

As evidenced by the recent spike in concerns about inflation, the asymmetric fears of too high inflation and the notion of taking away the punch bowl are still very much with us despite the experience since the global financial crisis.

Related Research

S&P Global Ratings' research
Other research
  • Most recent Fed dot plot:
  • PIIE paper by Orszag, Rubin, and Stiglitz:
  • History of the punch bowl metaphor:
  • Taylor Rule:

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