On Sunday morning, we spent some time assessing the possibility that the arrival of a coordinated, global fiscal stimulus push could finally break the back of the four-decade bond bull.
Any discussion around the likely trajectory of fiscal policy in the 2020s has to include at least a passing reference to modern monetary theory. Even those who demonstrate an almost pathological commitment to budget discipline have begrudgingly come around to the notion that fiscal largesse on a global scale is all but inevitable, if for no other reason than monetary policy has reached the limits.
It’s true that we don’t know how low rates/yields can go, and our assumptions on that have been proven wrong time and again. What we can say with confidence, though, is that they can’t drop in perpetuity. At some point, we will reach a floor (see the “reversal rate” discussion, for example), and we’re by definition closer to it now than we were a decade ago.
Similarly, there is a common sense constraint on central bank balance sheet expansion in its current incarnation. Without explicit coordination between monetary policymakers and the issuers of debt (i.e., governments and corporate borrowers), unrestrained asset purchases will eventually impair market functioning if issuance fails to keep pace with central bank buying.
Of course, as rates fall, borrowers will presumably issue more debt to take advantage of the favorable environment, but in the absence of overt coordination, it stands to reason that over time, central banks will end up owning a larger and larger share of some of the markets in which they operate. This, in turn, will necessitate the creation of special facilities for lending out and making markets in the assets which are sequestered away on central bank balance sheets in order to avoid a scenario where markets cease to function for lack of liquidity. Indeed, this isn’t confined to debt securities. The Bank of Japan recently created a facility for lending out the ETFs it owns.
The overarching message is that at some point, the world will either have to accept the prospect of lackluster growth and inflation, countenance experiments in even more extreme manifestations of accommodative monetary policy or else acquiesce to fiscal stimulus.
In all likelihood, fiscal stimulus in the new era will involve coordination with monetary policy. In locales where rates are already low and asset purchase plans are already operating, any fiscal stimulus undertaken will by definition be working in conjunction with monetary policy, unless the latter pivots to a tightening bias amid a loosening in the fiscal purse strings. Given how horribly awry 2018’s experiment in normalization went for monetary policymakers, it’s hard to imagine that central banks would tighten aggressively in the face of a concerted fiscal push, no matter how relieved they might be that some of the onus for reflating the global economy had been shouldered by politicians, and no matter how concerned they might be with the appearance of abetting deficits.
Given that, the only question going forward is how overt the cooperation will be.
Goldman’s Zach Pandl – the bank’s co-head of global FX, rates and EM strategy – recently delivered one of the more cogent, straightforward assessments I’ve read of the crossroads we now find ourselves at from the perspective of developing policy prescriptions in the face of endemic “slow-flation” dynamics.
Below are some key excerpts from Pandl’s remarks, abridged and presented in bullet point format for clarity and brevity. These should be considered in conjunction with the linked post above from Sunday morning.
- Monetary policy remains the first and best option for macro management, but it is plain to see that it has not been enough.
- Two of the world’s largest economies—the Euro Area and Japan, which together account for about 15% of global GDP, or about the same size as the United States—have held short-term interest rates below zero for half a decade and still struggle with weak growth and low inflation.
- In this environment, the same cost-benefit analysis that holds back fiscal policy in normal times arrives at different answers. Start with interest cost. What is the interest cost of zero-interest debt? This is not a trick question: it is zero.
- Concepts of debt sustainability also change when interest rates fall. Take for example an economy with a 100% debt-to-GDP ratio, 2% growth and 2% interest rates. In this economy, a primary deficit of 1% of GDP will add 1% to the debt stock, taking it to 101%. However, with this same mix of debt and deficits, if interest rates are zero the debt stock will actually fall by 1% to 99% of GDP.
- Numerous economies today face two interrelated problems: (i) weak real activity, and (ii) weak inflation, which is to say the purchasing power of money could fall quite a bit before becoming problematic. These challenges have a textbook solution: the government should consume resources and pay for this with new money rather than borrowing or taxes. This would simultaneously boost growth and raise inflation.
- The money would come from the central bank, which would either credit the government’s account or hold a government bond in perpetuity. This is not as radical as it sounds: essentially all governments, including the US, operate this way during major wars.
- The simplicity of this approach underscores an important point: if a country can borrow in its own currency, and faces a combination of weak growth and weak inflation, it has an institutional and political problem, not an economic one.