How will central banks respond to the Delta variant?

The highly transmissible coronavirus variant will complicate the Federal Reserve’s attempts to tread a fine line between retaining accommodative monetary policy and managing inflation
China, on the other hand, has more room for monetary policy manoeuvring

Neal Kimberley

Published: 4:30pm, 13 Jul, 2021

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Epidemiological evidence suggests the more transmissible Delta variant of the Covid-19 virus is becoming the dominant strain in many parts of the world. This will have serious and unavoidable implications for global economic activity.

China’s economy will not be immune, but Beijing has more flexibility than many to make necessary monetary policy adjustments.

The spread of more transmissible strains of Covid-19 is clearly an unwelcome development. Fortunately, so far at least, where mass vaccinations have been rolled out, those inoculations seem to be providing a measure of protection against the Delta variant even as case numbers rise rapidly.

Nevertheless, there will be economic implications from the virus’ resurgence and markets have already woken up to the risk. Amid clear evidence of the greater transmissibility and spread of the Delta variant, reflation trades have been unwound recently across asset classes, as the investing narrative has shifted towards the idea that the global economy’s initial post-pandemic rebound has already peaked.

But such is the scale of the Delta variant’s spread, central banks and governments will also have to think about fiscal and monetary policy responses.

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The global spread of the highly contagious Delta variant of Covid-19

In the United States, in the face of a rise in US consumer prices which it so far has dismissed as transitory, the Federal Reserve has been treading a fine line, retaining pandemic-related ultra-accommodative monetary policies while also seeking to reassure markets that it won’t let US inflation get out of hand.

Treading that line may just have got harder with the US Centres for Disease Control and Prevention now stating that the Delta variant became the most dominant strain of Covid-19 in the United States over the two weeks ending July 3.

Indeed Atlanta Fed president Raphael Bostic acknowledged on July 7 that if the spread of this more virulent strain does lead to “spikes in infections”, it could result in less economic activity and mean that the US “recovery is going to be a lot smaller”.

The situation poses significant challenges to the US central bank.

President of the Federal Reserve Bank of Atlanta Raphael Bostic has said a spike in Covid-19 infections in the US could hit the US’ economic recovery. Photo: Reuters

China too faces challenges but it still has plenty of monetary levers to pull if needed. Others may be more restricted in their policy options.

In comparison to others, as Sun Guofeng, head of the monetary policy department at the People’s Bank of China (PBOC) recently noted, China’s central bank’s balance sheet did not greatly expand last year in response to the pandemic. “In 2020, the balance sheet of the [PBOC] expanded by only about 3 per cent,” Sun wrote, “while those of the Federal Reserve, the European Central Bank and the Bank of Japan expanded by 77 per cent, 50 per cent and 24 per cent.”

That should give Chinese monetary policymakers more room than others to adjust monetary policy settings as the economic consequences of the global spread of the Delta variant of Covid-19 become clearer.

China better prepared for US Fed policy moves this time around, analysts say

One area of concern for Beijing may be China’s export sector. A key driver of the recent recovery of the Chinese economy has been the strength of the country’s exports, not least to the United States. Overseas sales might well be negatively affected if global demand is adversely affected by the spread of the Delta variant.

And that is without factoring in the existing erosion of profit margins in China’s export sector caused by rises in raw material prices related to post-pandemic bottlenecks, as evidenced again in the still-elevated Chinese producer price index data.

Women make toys for export at a factory in Lianyungang in east China’s Jiangsu province in January 2018. Photo: AFP

Additionally, the recent drop in the Caixin/Markit services purchasing managers index to 50.3 in June, a 14-month low, arguably suggests that, from a domestic perspective, China’s post-pandemic economic rebound has itself now topped out.

Such considerations help explain both the July 7 announcement by the State Council that China would lower the bank reserve requirement ratio as required to support the Chinese economy and the subsequent cut of 0.5 percentage points on July 9 for major commercial banks by the PBOC, effective from July 15.

The PBOC’s move will release 1 trillion yuan (US$154 billion) worth of liquidity into the interbank system, liquidity that can then be directed into more credit for small Chinese companies in need of support. This is Beijing taking monetary policy action in light of the changed circumstances.

Markets may continue unwinding reflation trades amid concern over the economic consequences of the spread of the Delta variant. Policymakers around the world might also decide additional monetary support measures are required. But when it comes to countering the economic impact of the Delta variant of Covid-19, few countries, if any, still have at their disposal as many monetary policy options as China.

Neal Kimberley is a commentator on macroeconomics and financial markets

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