Regime shift: the return of “fiscal activism”

High inflation remains a key focus for investors, driving the decisions of central banks, influencing bond yields and valuations across all asset classes. We expect central banks to succeed in taming the current high rates of inflation over the next 12 to 18 months. We do not, however, see a return to the period after the Global Financial Crisis (GFC) where policymakers struggled to generate sufficient inflation to meet their targets.

That period, often dubbed “lowflation” will be followed, in our view, by a phase where inflation is higher and more volatile. The headwinds which weighed on prices are fading and we are moving into a new regime characterised by supply side shortages and more frequent price increases (see Regime shift: investing into the new era).

Under this new regime monetary policy will have to remain focused on controlling inflation, potentially leaving a void for fiscal policy to manage growth, or a lack of it.

As a result, the balance between monetary and fiscal policy is expected to shift. The ultra loose monetary policies of the post-GFC period, where low interest rates combined with fiscal austerity, will be replaced by a new mix of tighter monetary and looser fiscal policy. In this note we look at the drivers of “fiscal activism” and its potential economic implications.

The trend toward fiscal policy has been reinforced by government intervention during the pandemic and more recently in response to the energy crisis in Europe. Increased populism has also been important, raising the pressure on politicians to be more active. Greater reliance on fiscal policy means that macroeconomic policy will become more political, as it presents choices, such as who and what to tax and where to spend, compared to the blunt instruments of monetary policy, interest rates and quantitative easing/tightening.

However, the path toward greater fiscal activism is challenging and risks serious conflict with central banks and the markets – as witnessed in the UK following the recent debacle of the “mini-budget”. As a consequence, increased fiscal activism may involve other more radical changes to the policy framework. A summary of our main conclusions can be found at the end of the article.

The return of “big government”, the rise of populism and changing political priorities

The pandemic experience has been a key factor in bringing about a shift towards fiscal activism. Governments around the world successfully intervened to support household incomes through furlough schemes and direct transfers while organising the roll-out of mass vaccination programmes. The recent energy support packages in response to the rise in costs triggered by the war in Ukraine are another example of successful intervention. The return of “big government” has led many to call for the authorities to be more active in other areas and more willing to use public expenditure to solve problems.

It is debatable whether the response to a one-off event like a pandemic or war should go on to justify the greater use of fiscal policy in more normal circumstances. Indeed, it can be argued that the fiscal response to the pandemic was excessive and sowed the seeds of today’s high inflation. Former US treasury secretary Larry Summers warned early on that president Joe Biden’s American Jobs Plan in 2021 would end up stoking prices. Judging the scale and timing of fiscal intervention has always been problematic and has often led to pro, rather than countercyclical stimulus, exacerbating the volatility in the economic cycle.

Nonetheless, the experience of the pandemic seems to have emboldened populists and anti-establishment parties alike who are regaining some of the momentum they had lost early on in the health crisis. Prior to the pandemic such parties had been taking an increasing share of the public vote, amid a lack of economic growth, rising inequality and increasing pressure on public services after the GFC. Italy, for example, has been in the vanguard of this trend with a coalition of right wing parties led by Giorgia Meloni taking power in October last year (chart 1).

The pandemic may have temporarily distracted attention, but the general concerns that economic policy was failing a significant proportion of the population who had seen no increase in real incomes in a decade have re-emerged. One sign of this can be seen in the wave of strikes to hit the UK economy. Workers are seeking higher pay awards to claw back some of the loss of real earnings from high inflation. Such a pattern ties in with research from the IMF which has shown that social unrest often follows pandemics. Those who made sacrifices during the health crisis are often disappointed at the lack of change after it has ended and are willing to push harder for something better.

Monetary policy has become less effective and more political

The desire for a more active fiscal approach also reflects increasing discontent with monetary policy. After years of driving growth, monetary changes seemed to lose their potency after the GFC. High levels of debt, damaged credit ratings and increased banking regulation combined to dampen the effect of looser monetary policy on economic growth. The lowflation period since the GFC also witnessed some of the weakest growth, despite the lowest interest rates on record for many economies.

To make matters worse, the use by central banks of asset purchases, or Quantitative Easing (QE), has been seen as instrumental in aggravating inequality. QE helped drive asset prices higher by reducing long term interest rates on government bonds and subsequently pushing investors along the risk curve. As a consequence, liquidity flowed from bank deposits and government bonds into property, equities and a range of other risky assets, the holders of which simply got richer.

Meanwhile, as the distribution of wealth became more skewed toward the top end, the squeeze on wage earners at the lower end of the income distribution increased. This occurred through wider changes in the world economy such as increased globalisation and the greater adoption of technology.

While these factors are beyond the scope of monetary policy, they added to dissatisfaction with the performance of the economy and are fuelling the call for a change of direction, increasing the appeal of populist parties.

Monetary policy is now focussed on bringing down inflation. Today, interest rates are rising and QE has come to an end in the US, eurozone and UK. Monetary policy is tightening to bring down inflation after its post-pandemic surge and we expect central banks will succeed in restoring some semblance of price stability in 2023.

Looking further out though we believe inflation will prove to be more difficult to control in the new regime. Challenges to globalisation as a result of geo-politics and an increased focus on the security of supply chains (which we will explore in part 3 of the regime shift series) and an accelerating response to climate change (the subject of part 5), are expected to be inflationary. Interest rates will need to be higher over this decade than they have since the GFC.

Consequently, the regime shift will mean that monetary policy will prioritise controlling inflation (the subject of part 1 of the series), potentially leaving a void for fiscal activism to manage growth. The balance between monetary and fiscal policy is set to shift away from a combination of loose money and tight fiscal, towards one of tight money and loose fiscal policy.

However, the path toward greater fiscal activism is challenging and may involve other possibly radical changes to the policy framework.

High indebtedness could set scene for conflict between governments, markets and central banks

As the previous UK government found to its cost with the mini-budget last September, replacing monetary policy with expansionary fiscal policy to drive growth is not straightforward. Monetary policy aims to regulate overall demand in the economy and adding an expansionary fiscal policy risks pushing interest rates higher with no benefit to overall growth.

The combination of restrictive monetary policy and expansionary fiscal policy has been likened to driving a car with one foot on the accelerator and the other on the brake. The return of fiscal activism to generate stronger growth risks a conflict with central banks.

The problem is made more acute by the high level of government debt such that an increase in interest rates and the cost of borrowing can be a significant constraint on public expenditure. Figures from the IMF show that the government debt to GDP ratio for the Advanced G20 surged to over 130% in 2020, an increase of over 20 percentage points when compared to pre-pandemic levels in 2019 (chart 2). Government support through furlough schemes, fiscal transfers to households and the roll-out of vaccines account for much of the increase.

This is now ebbing as fatalities drop and the virus becomes more endemic, although expenditures remain high as health systems deal with the backlog of untreated cases. Energy support for households and businesses are also adding to borrowing. Economic recovery is bringing the debt to GDP ratio down and the IMF expect it to stabilise at around 125% for the Advanced G20, off the peaks, but still well above pre-pandemic levels.When combined with the shift to a new regime of higher interest rates, the cost of government borrowing will increase going forward. Figures from the IMF suggest that for the G20, interest costs will have risen from a low of just over 1% of GDP last year to 1.5% this year and to nearly 2% by 2025. The recent rise in global government bond yields suggests this could be reached more rapidly and be higher (chart 3).

So far we have highlighted the increasing demands for a more active fiscal policy and the challenges posed by potential conflict with monetary policy and high existing debt levels. The situation is very different from the period when John Maynard Keynes proposed fiscal policy as a means of lifting the economy out of depression and deflation in the 1930s. High unemployment and falling prices meant that direct government spending was a means of boosting growth at a time when there were fears that monetary policy had fallen into a liquidity trap whereby it had become ineffective as the banking system was contracting. Today, inflation and not deflation is the problem, monetary policy still works and government debt is significantly higher.

On this basis governments wishing to be more fiscally active have to retain a credible fiscal framework in their budgets where, for example, the debt-to-GDP ratio stabilises over the medium term. Otherwise, they risk the ire of the so-called bond market vigilantesand seeing extra expenditure eaten up by higher interest costs as markets sell off.

This means that there will be a greater focus on what economists term “fiscal space” which is defined by the IMF as: the room for undertaking discretionary fiscal policy relative to existing plans without endangering market access and debt sustainability. The ability of a government to be more fiscally active and offset tighter monetary policy will depend on how much fiscal space it has.

There is no hard definition of how this should be calculated, but governments have more fiscal space the lower their deficit and debt levels, the longer the debt’s maturity, the lower their non-debt liabilities (such as unfunded pension obligations), their dependence on overseas investors and their track record of meeting obligations. Table 1 shows some of these factors for a selection of economies along with their S&P rating.

In this respect fiscal space and the scope for a more active fiscal policy is greater in AAA rated Germany and Canada than BBB Italy reflecting their relatively low levels of borrowing and debt, for example. However, we would caution against reading too much into this: as part of the euro area Italy will be supported by the wider group with the European Central Bank promising measures to control the widening of Italian bond spreads. Meanwhile, fiscal metrics for the US are not the strongest, but as a safe haven bond market it should have more space than other AA rated countries such as the UK. We recognise though that the forthcoming debate over the debt ceiling will put this to the test.

Pathways to active fiscal policy: work within the existing system, or change it

In the new regime, governments will be testing the limits of their fiscal space. Many will simply accept the impact of additional spending on monetary policy and decide that greater public borrowing for political priorities is worth the pain of higher interest rates. For example, increased spending on health and the care of the elderly could be seen as meeting public demand and improving welfare. It could also help the supply side of the economy by getting sick people back to work and relieving the labour shortages created by the pandemic.

Nonetheless, if not offset by higher taxes or cuts in spending elsewhere, the cost of fiscal activism will be higher budget deficits and higher interest rates. Consequently, growth would be skewed away from the more interest rate sensitive sectors of the economy toward the public sector and its suppliers. This would be a case of public “crowding out” private activity as greater health spending would displace activity in private housing, for example.

Would this matter? Although overall GDP growth might be the same, the increase in provision of public services may well increase satisfaction amongst the population with the economy. To mitigate the impact on financial markets and interest costs the government would have to argue that the increase in public spending would boost long-run growth in the economy. As a consequence, it may well have to be focussed on capital spending and training to raise long-run productivity.

Alongside spending on health, this could include increased investment in the regions where productivity has lagged, combined with increased spending on mitigating and developing technologies to counter climate change.

This is by no means a universal view. Others would be concerned about the increase in the size of the state and the burden of higher taxes on incentives to work and invest. If the increase in interest rates proved to be too much of a constraint, then the authorities would have to look at higher taxation and more redistributive policies to reduce the budget deficit. In the current environment where existing taxes are already high in many economies, we could see new taxes on land, or wealth more generally, come onto the agenda.

Another, less contentious, route would be to fully implement the OECD’s 15% minimum tax rate on corporations designed to capture the evasion of tax by many multi-nationals, particularly large tech companies.

Clearly there are political choices to be made and as well as higher taxes or spending cuts, there would be renewed interest in questioning the limits of the state and privatisation. If none of these are acceptable, the alternative is to be more radical and look to change the existing system.

Radical changes: controlling the bond market vigilantes

In this respect, the approach would be to increase financial repression and control the bond markets such that the bond market vigilantes are unable to push yields higher on concerns about increases in government borrowing. To some extent this happened under QE where central bank purchases of government bonds helped keep yields in check and the proportion of negative yielding bonds reached nearly 30% of the global market (see chart 4).

Further QE seems unlikely given that central banks will be fighting inflation and the adverse consequences discussed above. Instead, regulation could be used to direct funds into the bond market, for example by increasing requirements on investing institutions to hold more government paper. A number of countries already do this on the grounds of prudence.

However, by weakening market discipline in this way there would be a greater risk of higher inflation by keeping rates lower than otherwise and so those pursuing this route would also consider changes at the central bank. This might mean altering their mandate to one which would tolerate greater inflation. For example, increasing the inflation target, or adopting a more explicit dual mandate of inflation and employment goals. The ultimate sanction would be to rescind central bank independence and for the authorities to take back control of monetary policy.

Of course, any of these measures would provoke a violent reaction from financial markets. Governments would also have to think hard about the consequences, particularly higher inflation.

Even then it might be argued that high inflation would be welcome as it would inflate away high debt levels. In practice this option may not exist. Higher inflation may boost nominal GDP and hence reduce the debt to GDP ratio. The impact on the public finances though is complex and will vary by country. Higher inflation boosts the tax base, but exacerbates spending pressures. Much public spending is inflation linked, particularly pensions and benefits. Public sector wage bills will also rise.

The key will be the impact on borrowing costs. Although the government is effectively controlling interest rates through financial repression, some borrowing costs will increase as inflation rises such as those on inflation or index-linked bonds. The UK is particularly vulnerable in this respect given it has one of the highest levels of outstanding inflation-linked debt at 25% of the total. Other major economies are running at 10% or less, according to the Bank for International Settlements.

The market risk is that, faced with a yield discount on their bond holdings, international investors would reduce their support and in some cases sell, thus hitting the currency. Economies running current account deficits and so dependent on the “kindness of strangers”, as a former Bank of England governor put it in relation to the UK, would be particularly vulnerable. Other forms of financial control would then be necessary such as capital controls.

When all economies were engaged in financial repression through QE, investors had little choice but to accept the reduction in yields. In a new regime of higher rates and tighter liquidity it would be more difficult for individual countries to pursue independent financially repressive policies. Only those with the strongest domestic funding would be able to do this as, for example, Japan has demonstrated. Even Japan, though, is seeing higher inflation and has been pressurised via the weakness of the yen to change tack and accept higher interest rates.

Summary and conclusions

• Although central banks are expected to win the near term battle with inflation, looking further out monetary policy will have to remain focused on controlling inflation, potentially leaving a void for fiscal policy to manage growth, or a lack of it.

• Spurred by the pandemic and a revival in interest in big government, fiscal policy has moved up the political agenda after more than a decade when monetary policy has failed to meaningfully boost economic growth.

• As a result, we see a new regime of more active fiscal policy where the balance with monetary policy is expected to shift. The ultra loose monetary policies of the post-GFC period, where low interest rates combined with fiscal austerity, will be replaced by a new mix of tighter money and looser fiscal policy.

• However, the path toward greater fiscal activism is challenging and risks serious conflict with central banks and the markets. There is a danger that the authorities will be driving the economy by pressing on the brake and accelerator at the same time. Politicians will need to be wary of aggravating inflation and seeing borrowing costs soar.

• Governments will have to maintain fiscal credibility as greater activism will mean increased scrutiny from markets on their room for manoeuvre, or fiscal space.

• Greater public capital spending, including health and climate solutions, to raise long run productivity and improve the supply side of the economy will be important in making the case for fiscal activism. If investors are not convinced, efforts to increase spending or cut taxes will falter.

• Despite the risk of increased volatility in the bond markets, in the face of widespread discontent with the economy and rising populism, we expect a shift in economic policy to one of tighter money and looser fiscal policy.

• Economic policy will become more political as fiscal policy inevitably means more decisions on spending and tax, creating winners and losers. Under this new regime we are likely to see shifts in the mix of activity as higher government spending crowds out activity elsewhere, particularly in interest rate sensitive sectors.

• Otherwise the only option is to be more radical and counter, or neutralise the bond market vigilantes. One route would be to increase central bank inflation targets, another would be to rescind central bank independence altogether and use regulation to suppress bond yields.

• Economies with large externally funded current accounts will still be vulnerable to capital flight as they depend on international investors. When all economies were engaged in financial repression through QE, investors had little choice but to accept the suppression in yields. In a new regime of globally higher rates and tighter liquidity it would be more difficult for individual countries to pursue independent financially repressive policies.

For more on the market and economic implications of regime shift visit: www.schroders.com/regimeshift