Fiscal Cavalry Trots to Inflation Battle

Cohen

Economic Trends

Summary:

With world markets in thrall to the final big three central bank meetings of a tumultuous year next week, the parallel world of fiscal policy takes a back seat.

With world markets in thrall to the final big three central bank meetings of a tumultuous year next week, the parallel world of fiscal policy takes a back seat. And yet it may be just as crucial to next year's economic and financial outlook.

In one of the starkest economic lessons of a year bamboozled by war in Ukraine and an energy shock, Britain discovered that reining decades-high inflation with interest rates alone is much harder if fiscal policy is rowing in the opposite direction.

The UK's disastrously botched giveaway budget in September set out for many the limits of what's possible in a world of double-digit inflation. Loosen the public purse strings any further and the commensurate level of interest rates needed to then get inflation back to 2% targets balloons, and risks melting the economy down in other ways.

With perhaps less vulnerability to foreign investment flows and currency shifts than Britain, the United States and euro zone have been dancing with that problem too amid serial economic rescues and recovery plans over three years of pandemic, war and energy crises that hit the trillions.

For all intents and purposes, the past three years have been the budget equivalent of a war footing for Western governments. Just as inflationary too - and in need of normalising.

But the room for and extent of the fiscal clawback in 2023 and 2024 may well determine how much harder central banks have to squeeze credit from here.

Less in need of same level of new energy price supports Europe was forced into, U.S. government spending was already checked this year by Democrats' razor thin Senate majority and the objections of Democratic Senator Joe Manchin.

That majority increased by one after last month's mid-term elections and this week's Georgia runoff. But Democrats lost the House of Representatives by a narrow margin too and that likely enforces rather than loosens spending gridlock.

Britain's bond blowup in September, meantime, forced a swift change of prime minister and finance minister and a dramatic fiscal U-turn that now ushers in austerity more than stimulus.

A hazier picture prevails in the European Union, where support for Ukraine, higher military spending and EU attempts to wean itself off Russian natural gas and oil leaves less room for retrenchment.

In its latest economic outlook late last month, the Organisation for Economic Cooperation and Development reckoned energy uncertainty clouded the picture but "moderate" fiscal consolidation was indeed still likely over the next two years.

The median OECD economy was forecast to see an improvement of underlying primary budget balances, which exclude interest payments on outstanding debt, by some 0.4% of potential GDP next year and 0.6% in 2024.

And the United States stands out in that regard. The OECD sees a full 2% of potential GDP improvement in its primary balance over the two years combined.

And yet while inflation lifts nominal GDP and public revenues, the hit from a real GDP recession, higher debt servicing costs and lingering or poorly-targetted energy supports sees total debt burdens continue to climb.

Only Sweden, Portugal, Ireland are set to have lower debt/GDP ratios in 2024 than in 2019, according the 38-member OECD.

Describing the debt service outlook as having "deteriorated substantially", it said long-term borrowing costs of 10 years or more had risen significantly above so-called "implicit interest rates on public debt" - the interest paid as a share of the nominal debt stock. And this simply pointed to "more costly debt finance in the future".

'Brute force'

All of which begs the question of whether central banks will have to conduct the inflation fight on their own.

Some try to see it terms of the "monetary policy space" a government's spending and debt accumulation - and that of companies and households - affords its central bank.

Societe Generale strategist Solomon Tadesse this week modelled it over time, looking at whether a greater fiscal burden and higher debts over recent decades - supported by low interest rates or outright central bank bond buying - had in fact lowered the point at which higher interest rates bowl the economy over.

Tadesse pointed out that the Federal Reserve of former chair Paul Volcker was able to raise interest rates as high as 19% in the 1980s without causing a recession - but recession now looms again with Fed rates approaching a quarter of that.

He blames "fiscal indiscipline" over the intervening period and fears the limit that imposes on the use of interest rates to control inflation just risks baking in bloated central bank balance sheets in a "vicious circle".

And likely severe recessions from historically modest interest rates just force central banks to quickly return to so-called quantitative easing, undermining their own longer-term inflation battle.

"For markets, brute force monetary tightening without concomitant fiscal discipline that significantly slashes budget deficits and debt financing may only provide a temporary reprieve - if any at all," Tadesse said. "Sustainable normalisation out of the current crisis would call for meaningfully addressing deficit financing."

Using the Fed's overall U.S. government debt holdings as a proxy for fiscal discipline, Tadesse estimated that a reduction from current levels of about 25% of GDP to pre-pandemic levels of 10% could create greater monetary policy space - allowing a peak policy rate of 9.85% without triggering a hard landing.

It would also allow the Fed to shrink its balance sheet by about $4.36 trillion, reversing almost all of its pandemic QE.

Debates rage about the real causes and durability of this inflation surge, the connection between public debt and economic activity and the extent to which deficits matter at all.

At the very least, a test of these ideas is coming. If the Fed and other central banks pause tightening to cope with rising unemployment next year, it's not yet clear they'll have succeeded in putting inflation back in its box by then. Fiscal Cavalry Trots to Inflation Battle_2

Fiscal Cavalry Trots to Inflation Battle_2

Source: Reuters

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Fiscal Cavalry Trots to Inflation Battle

'Brute force'

Source: Reuters

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