The policy inversion

With global economic policy preferences being the opposite of those seen after the 2008-09 crisis, so should be the implications

Despite headline inflation having moderated meaningfully from the peak, bond yields in the US, EU, and the UK are still near 15-year highs, likely in anticipation of a more gradual fall in inflation going forward. Mortgage rates in the US and the UK are still near peaks they hit last year. Two months back, this column had flagged the risks of monetary policy having to tighten excessively to control inflation as fiscal policy remained loose (“The tap still left open”, Business Standard, May 9, 2023). These risks are now becoming manifest: In economies where fiscal interventions were moderate, like Japan, China and India, the problem is noticeably less severe. A loose fiscal policy in the US also helps explain why one of the most anticipated recessions has still not started.

Over the decades, many economists have highlighted the link between fiscal policy and inflation (as in the seminal 1981 paper by Sargent and Wallace “Some Unpleasant Monetarist Arithmetic”). A recent study by the Bank for International Settlements supports this connection, finding that a one percentage point increase in the fiscal deficit can lead to inflation rising by 10 to 50 basis points over the next two years. The impact is most severe under a fiscally led regime, that is, when the government places less emphasis on stabilising debt and monetary policy is less committed to price stability.

Conversely, high fiscal deficits have the least impact on inflation when fiscal policy is prudent (that is, governments target a stable debt-to-gross domestic product, or GDP, ratio), and monetary policy is independent. Of the 21 advanced economies they studied till 2011, just one was fiscally led. However, based on definitions provided, current policy choices in advanced economies point to worst-case outcomes.

According to the International Monetary Fund’s (IMF’s) fiscal monitor, fiscal deficit in the advanced economies this year is expected to be 4.4 per cent of GDP, well below the 10.2 per cent of GDP in 2020, but the highest since 2012, excluding the Covid period. While higher interest rates do increase the governments’ debt burden, even the primary deficit (fiscal deficit minus interest costs) is not expected to fall much going forward.

This policy is exactly the opposite of the one chosen after the 2008-09 crisis, when developed economies chose monetary easing and fiscal tightening. The unsavoury side-effects of that policy — a long and arduous recovery in the job market, and worsening wealth inequality as financial assets became more expensive — likely contributed to the inverted stance. So far, wage growth for the bottom quartile in the US has exceeded that for the top quartile. Unemployment rates have come down too for the less educated and economically weaker communities. Politically, therefore, there is little compulsion for governments to attempt faster fiscal consolidation. The deficit ratio is forecast by the US Congressional Budget Office (CBO) to remain in the current range for the next several years.

This has two important implications. First, we must pay more attention to forward-looking indicators of fiscal policy, instead of just tracking inflation, which, in this framework, is to some degree a backward-looking indicator. Second, global monetary conditions are likely to remain tighter for longer. Given that the economic impact of higher interest rates does not just depend on the peak interest rate (which most forecasters believe is near), but also the duration for which they remain elevated.

Fiscal tightening and monetary easing over the decade preceding Covid had driven up prices of financial assets, pushing the global wealth-to-GDP ratio to 4.9 from just 3.7 in 2012. As GDP is a measure of income, and financial wealth is mostly related to future incomes, a large part of the increase in their ratio can be attributed to a change in the discount rate. A sustained period of high rates should result in this ratio declining again, creating new vulnerabilities for growth (a drop in wealth can mean weaker risk appetite) and stability (matching assets and liabilities).

Policy spillovers would also be different: That is, the unintended impact of US policies on other economies. Whereas easy monetary policy benefits economies dependent on foreign capital flows, like countries running current account deficits, the first order effect of continuing fiscal stimulus would be to benefit countries having trade surpluses with the US. Continuing monetary tightness raises the risks from rollover of debt taken by frontier and emerging markets over the next few quarters. For India, a surge in services exports over the past three years is reducing external account vulnerabilities. Stronger wage growth in the US, an intended outcome of their fiscal policy, should also support Indian services exports. However, for several other economies, fewer and more expensive dollars would mean sustained economic pressure.

Over time, more serious concerns might emerge, like on the use of US treasuries as global safe assets. This currently appears premature and rightly so as there is no credible alternative to the dollar. However, sustained high interest rates can pressure assumptions underlying debt sustainability. Many assume an inflation-driven fall in the debt-to-GDP ratio, simplistically modelling that the inflation-driven rise in nominal GDP would bring down the ratio due to the growth in the denominator. However, in the US, this ratio is instead forecast to rise steadily for the next decade despite the primary deficit remaining steady, due to the growth in interest payments. These are set to rise from 1.9 per cent of GDP in 2022 to 3.7 per cent of GDP in 2033. While the debt-to-GDP ratio has indeed corrected for the euro zone from the peak in early 2021, it is still materially higher than pre-Covid levels.

Some economists believe this lack of confidence in debt sustainability is the reason behind the rise in inflation. One of the major reasons that high sovereign debt ratios in the advanced economies were considered sustainable was low interest rates. The longer interest rates remain high, the greater the refinancing risk at higher interest rates and the risk of fiscal dominance that perpetuates higher inflation.

Some researchers believe that just as in the 1960s the Triffin dilemma raised questions about the dollar’s peg to gold, predicting the breakdown of the peg in 1971, a “new Triffin dilemma” could raise concerns about whether US treasuries can be backed by future taxes. This becomes particularly important as central bank holdings of treasuries have peaked, and a growing share of non-sovereign holdings means these assets will increasingly be subject to market scrutiny.

The writer is chief economist, Axis Bank, and head of global research, Axis Capital