Column: Did you miss the mix? The fiscal space shapes the central bank’s view:Mike Dolan
London (Reuters) – Markets may not have the right mix.
Some people say that investors are missing the bigger picture of how economic policy will shape the years to come because they are too busy trying to read the monetary policy tea leaves every hour.
One of the main ideas of the decade before the pandemic was that western governments relied too much on their central banks to support the economy. Instead, they preferred a policy mix that kept budgets tight while real interest rates went down to keep demand up and prevent deflation.
Everything seemed to change in just two years after COVID-19 happened. Governments break the banks to keep economies going during lockdowns. As a result, deficits and debt levels go up, and central banks buy bonds and keep interest rates at zero to cover the extra borrowing that is needed.
But now that growth, jobs, and inflation are on the rise again, the reversal of interest rate cuts raises questions about how much fiscal firepower will be left in the long run, especially if borrowing rates stay high for a long time and economies slow down again quickly.
Last week, the non-partisan U.S. Congressional Budget Office showed what at first looked like a dramatic fix to bring the national accounts back to where they were before the pandemic.
The CBO said that the national budget deficit will shrink by more than $1.7 trillion this year compared to 2021. It will fall from an eye-popping 12.4 percent of GDP last year to 3.9 percent this year and then to 3.7 percent in 2023.
At least for the Treasury bond market, which is getting ready for the Federal Reserve to start getting rid of the U.S. debt it bought up during the pandemic.
But the CBO’s surprise in 2022 didn’t do much to hide the fact that the country’s finances will get worse over the next ten years because of already-agreed-upon recurring spending and rising interest costs.
It now thinks that the total budget deficit over the next 10 years, from 2011 to 2031, will be $14.5 trillion, which is $2.4 trillion more than what it thought in July.
In addition, interest payments on the national debt were expected to more than double to 3.3% of GDP by 2032.This would bring the debt-to-GDP ratio to a record 110 percent with an average interest rate of 3.1 percent, compared to 98 percent this year with an average rate of 1.9 percent.
https://fingfx.thomsonreuters.com/gfx/mkt/zgpomelampd/One.PNG IMF Chart on the World’s Budget Gaps
Real 10-year yields for the G7 can be seen at http://fingfx.thomsonreuters.com/gfx/mkt/lbvgndyjbpq/Four.PNG.
NO MORE ‘GREAT COINCIDENCE’
Congress has put a hold on any more “mega fiscal stimuli” because they are afraid of overheating the economy and causing inflation rates to reach levels not seen in almost 40 years. Those who have argued for some fiscal restraint now look like they were right, as the Fed is now tightening credit.
Last week, former Democratic Treasury Secretary Larry Summers warned about fiscal policy again and said that the Federal Reserve was slowly taking over. In an interview with The Economist, he also said that every time in the last 100 years that inflation was above 4% and unemployment was below 4%, a recession happened within two years.
Still, this year’s additional energy shock from Russia’s invasion of Ukraine and related sanctions may mean that households around the world need more financial help, like Britain’s announcement last week that it would give households an extra 15 billion pounds ($18.92 billion).
How these fiscal and monetary levers are set up is very important for investors trying to figure out where real interest rates will settle and how economies will handle the effects.
The head of the Amundi Institute, Pascal Blanque, thinks that the “Great Coincidence,” a time when monetary and fiscal policies worked well together, is over. From now on, he says, economic policymakers will have to work harder to negotiate and coordinate their actions.
Everyone will notice how well-planned the meeting between U.S. President Joe Biden and Fed Chair Jerome Powell was on Tuesday, with lowering the high cost of living at least being the public’s top priority.
Blanque thinks that the markets are currently leaning toward a combination of full “normalization” of monetary policy and more growth in government spending. But he calls the last one a “fiscal space killer” and says that the big risk with this mix is that the economy falls between the stools, which could lead to recession or stagflation and make risky assets like stocks go down even more.
He comes to the conclusion that it’s probably more likely that central banks in both Europe and the US will make some room for more fiscal action. He also says that this should fill portfolios with assets that protect against higher inflation for longer, to a greater or lesser degree.
The “fiscal space” will be used to address important new public goods such as the energy transition or social and strategic autonomy, according to Blanque.”Central banks will have to work together and keep these priorities in mind.”
CBO’s 10-year forecasts for the US budget deficit: https://fingfx.thomsonreuters.com/gfx/mkt/akvezryeqpr/Two.PNG
Long-term projections of the US public debt by the Congressional Budget Office (CBO): http://fingfx.thomsonreuters.com/gfx/mkt/byvrjdnmrve/Three.PNG
The author is Reuters News’s editor-at-large for finance and markets. Any thoughts he has here are his own.
1 dollar equals 0.7930 pounds.
(Written by Mike Dolan, Twitter @reutersMikeD; edited by Tomasz Janowski)
