Policy makers will turn to unconventional fiscal policy to deal with the next recession, says strategist Peter van der Welle.
Traditionally, policymakers seeking to mitigate the impact of cyclical downturns have had two instruments at their disposal: fiscal and monetary stimulus. Given the anticipated backdrop of elevated recession and financial stress risks in the next five years, as well as the apparent inability of central banks to make the rate cuts required, it is vital that investors consider the monetary and fiscal space that policymakers still have.
In our view, the ability (monetary/fiscal space) and willingness of policymakers to use the macroeconomic policy space available to them will, to a large extent, determine how asset markets evolve in the medium term.
So, how to define the fiscal space? Husband and wife team Christina and David Romer of the University of California do so by looking at a country’s gross debt-to-GDP ratio, where a lower ratio signals more fiscal space. They investigated how the ex-ante availability of monetary and fiscal space prior to a financial crisis influences subsequent economic growth.
Using a unique financial stress metric, they found that the presence or absence of policy space had a significant effect on the degree to which a financial stress event reduced GDP. For countries with policy space, GDP fell just 1% overall following a financial stress event, whereas countries with neither fiscal nor monetary policy space experienced a decline of almost 10%.
Also, when policy space was ample, more aggressive use was made of monetary and fiscal policies. Where policy space was available and used, financial distress proved to be less persistent. Policy space will become a key market driver in turbulent episodes ahead.
The concept of monetary space is arguably more tangential. Romer and Romer define it as “whether the policy rate is above the zero lower bound”, when the short-term nominal interest rate is at or near zero. The Romers see a nominal policy rate above 1.25% as an indication that there is policy space.
We find though that this neglects the possibility that the neutral policy rate for a country may actually lie below this 1.25%. If the neutral rate were, say, 0.75%, lowering the policy rate by 25 basis points from 1.25% to 1% in the event of financial distress would be equal to just a lower degree of net tightening of monetary policy, not a net stimulus.
Therefore, we like to define conventional monetary policy space more narrowly; the policy rate above the effective lower bound determines the policy space. The effective lower bound is the point at which a monetary authority is unable to reduce interest rates further and must therefore consider unconventional options.
Accommodating the real economy will become more challenging. Given today’s low neutral rates of interest in advanced economies, the reality is that central banks will hit the effective lower bound very soon, even with a modest drop in neutral real rates, leaving them largely unable to insulate the macroeconomy against a negative demand shock via a conventional policy rate setting.
The room available to cut interest rates matters. In the absence of monetary space, the Romer study noted a peak decline of 9.5% in GDP, while in the presence of monetary space, GDP showed a more modest peak decline of 3.0%. Romer and Romer also studied several cases of GDP evolution involving no monetary space. They looked specifically at Japan in the second half of 1997 and Portugal in the second half of 2008. We, therefore, have analyzed the equity markets of these countries following the financial stress events in those years.
It turns out that the equity returns in the subsequent five years were remarkably consistent. Both markets declined by 40% after the start of the financial stress event. While it is clearly unwise to draw firm conclusions from this anecdotal evidence, the absence of monetary space in advance of financial stress events clearly seems to matter.
The same holds for fiscal space. Without this flexibility, the fall in GDP following a crisis shows a peak decline of 8.8%, whereas with it the peak decline is just 1.6%. Again, case studies confirm this pattern in financial market impact. Looking at equity returns during episodes when there was no fiscal space in Japan and Italy shows large losses on the subsequent five-year horizon, whereas equities managed to recover when fiscal space was available prior to the financial stress event.
Our framework is based on normalized data from 17 major countries, to allow cross-country comparisons and ranking, as shown in the table below. Countries that have limited fiscal space typically seem to have limited monetary space as well, while the converse is not always true (as seen with the Eurozone).
For countries where monetary policy is constrained, it is therefore not obvious that fiscal policy can fill the gap. One escape route is to maximize the effectiveness of unconventional monetary policy; the other is to seek refuge in unconventional fiscal policy. Diminishing returns on unconventional monetary policy will push policymakers increasingly towards (un)conventional fiscal policy.