A new era in monetary policy

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The Covid-19 pandemic continues to spread with more than 30 million infections and 900,000 deaths. The good news is that there has been made a lot of progress in treatments and the development of vaccines, but the outbreak of second waves shows that the pandemic is far from being under control. The future path of the pandemic remains undoubtedly the main economic driver for the time being.

Nevertheless, it looks like the worst scenarios could be avoided. Major central banks have played an important role in combating the economic damage caused by the pandemic. Unprecedented monetary stimulus was necessary to prevent the Covid-19 crisis from turning into a larger depression. So far, the implemented measures since March 2020 have been extremely successful.

In the last days, central banks came back into the spotlight with important updates around the future path of monetary policies around the world.

First, the European Central Bank (ECB) expectedly left its policy rate unchanged at -0.5%. The ECB slightly revised its 2020 GDP outlook: It expects a less severe GDP contraction of 8%, versus its previous estimate of -8.7%. The estimates for 2021 and 2022 remain unchanged at 5.0% and 3.2%, respectively. Also, the inflation outlook remains unchanged at 0.3% for 2020, 1.0% for 2021 and 1.3% for 2022. Finally, one of the most relevant comments by Christine Lagarde, president of the ECB, was that “it is not necessary to overreact to the appreciation of the euro” because, although it may affect inflation in the medium term, the Central bank does not have a rate exchange rate target, therefore, no measure to influence the exchange rate are expected.

Second, the Bank of England (BoE) kept its benchmark rates at 0.1%, as expected. However, it said that if the economy was facing rising unemployment or a second wave of contagions that could endanger the economic recovery, it would not rule out implementing negative reference rates. This comment caused a drop in the British sterling pound.

Finally, the most important central bank announcement came from the Federal Reserve. Chairman Jay Powell fleshed out a new era monetary policy in different speeches during the last weeks. The most important announcements were made at the virtual Jackson Hole symposium and the press conference that concluded the regular two-day FOMC meeting.

At first glance, the speeches appeared relatively uninspiring. However, listening carefully and reading between the lines, they probably triggered the most important policy change since 2012. At that time, Fed Chair Ben Bernanke declared that the US Central bank would continue with its dual mandate of price stability and full employment, but he changed the inflation target from 1.5% to 2.0%. Now, Jay Powell has indicated that the Fed is targeting “average” inflation of 2% and that it will tolerate higher inflation for “some time”. Since inflation has been below 2% for quite some time, most market participants agreed that the announcements probably signalled that interest rates might well remain at the current low levels until at least 2023.

It is too early to fully understand the consequences of the new policy regime. The ongoing stimulus might help speed up the economic healing process, but it might also increase the appetite for riskier asset classes and cause bubbles in certain areas. The more logical conclusion is that conservative investors will continue to have a hard time to meet their return target, given the low yield environment in traditional fixed income markets. Therefore, they should continue to explore fixed income alternatives that offer more attractive risk-adjusted returns.


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