The Great Policy Rotation
Successful Fiscal Expansion Could Mean Market Uncertainty
By James McCormack
Unconventional monetary policies have been better for asset prices than the real economy. “Fiscal reflation” may be the opposite.
The shift in policy emphasis toward greater fiscal easing in many advanced economies could support economic growth in the short term, but may be accompanied by financial market disruption. With markets so closely linked to the policy backdrop, investors should be sensitive to the risks ahead.
Policy settings at the European Central Bank and Bank of Japan, and the Bank of England’s post-referendum initiative, indicate that continued monetary easing outside the US is a certainty in the coming months. This is despite policymakers and markets’ increasing awareness of the unintended consequences of negative interest rates — most notably for bank profitability and the viability of pensions — and recognition that the benefits of easing are more evident in financial asset prices than the real economy. The first of these considerations has resulted in policies becoming increasingly complex, particularly in Japan. A widely drawn conclusion, based in part on central bank officials’ admissions that additional easing offers diminishing returns, is that monetary policy is running out of options and room to operate.
The “Three Arrows” of Abenomics Go Global
The international policy community is building a consensus that stronger growth requires current easy-money conditions to be maintained (except by the Federal Reserve) and supplemented by greater fiscal stimulus. The G20 leaders’ communique following the Hangzhou Summit tellingly listed “potential volatility in the financial markets” as the leading downside risk to the global economy, ahead of commodity prices, weak trade and investment, slow productivity and employment growth. Recognition of financial market volatility as the key global risk — when markets are being driven intentionally by central bank actions — point to a clear continued accommodative bias to monetary policy.
In the July update of its World Economic Outlook, the IMF sounded decidedly Japanese, making reference to the need for demand support and structural reforms “without leaving the entire stabilisation burden on the shoulders of central banks”. This will be a recurring theme at the upcoming IMF/World Bank annual meetings, where it is likely to face little, if any, opposition.
In Europe, the fiscal requirements of the Stability and Growth Pact are effectively non-binding for the time being, as shown by the Commission’s recommendation in July to impose no fines on Portugal or Spain after the Council found that neither country had taken sufficient action to correct excessive deficits. This reflects the political realities of today’s Europe, where anti-EU sentiment is high, and most evident on issues surrounding security and migration, and the imposition of fiscal austerity.
The absence of much debate on the traditional “three Ts” of fiscal expansion (timely, targeted and temporary), probably because they are already agreed, provides further confirmation of the growing acceptance of pending fiscal easing. The consensus seems to be that the right time is now, the best target is infrastructure spending, and whether it is temporary depends on how long central banks can keep interest rates lower than GDP growth, which is a reasonable proxy for the return on infrastructure investment.
Successful Fiscal Expansion Could Mean Market Uncertainty
There is plenty of evidence that monetary policy has not been as effective as desired at raising inflation and supporting economic growth in recent years. The most compelling is the degree to which “unconventional” policies have become accepted as necessary and rolled out with less surprise and impact over time. But there is no reason to believe that traditional fiscal policy will not work, at least in the short term, if large spending projects that contribute directly to GDP are undertaken, as is currently contemplated.
There are two reasons why financial markets could react unfavourably to successful fiscal expansion. First, there may be concerns that a return to stronger economic growth would weaken the case for continued monetary easing. Even without an immediate pickup in inflation, a growth spurt could call into question the justification for maintaining exceptionally easy money. Second, a “fiscal reflation” is possible, whereby an investment-led surge in growth contributes to higher prices and wages. Investment is typically more trade-intensive than consumption spending, and employment related to trade usually commands higher wages. This also lends support to the view that co-ordinated fiscal policy is most advantageous, as there can be cross-border growth support.
Successful fiscal scenarios would conflict with the understanding that policy interest rates will remain “lower for longer” and that inflation is improbable into the medium term. Given how widely accepted these tenets are, and the degree to which market positioning is aligned with them, what may turn out well for the real economy might be considerably less positive for financial markets. This is a risk for investors and policymakers alike.
The final risk with the turn to fiscal stimulus is that it does not work. Fiscal expansions are ultimately intended to be displaced by private sector growth that, once spurred by public spending, gains its own traction. An alternative and much less appealing result is a quick return to lower growth but with higher government debt when public spending has run its course. In that scenario, it would not only be Japan’s “three arrows” that other advanced economies emulate.