But at the same time, tepid growth and low inflation have led governments to pursue or step up active monetary policies using unconventional tools like sovereign debt purchases.
Today, the situation has changed. Central bank asset purchases will amount to more than USD 500bn in the fourth quarter but the effects of such unconventional means on the economy and, more importantly, on the financial sphere, have more and more become the subject of debate. Their consequences are increasingly visible through various financial distortions.
At the same time, although few developed countries have managed to balance budgets, most have achieved a sharp reduction in primary deficits. Admittedly, there are still a few exceptions and government debt levels remain high. Should governments pursue efforts whose economic cost is clear when interest rates are at historically low levels?
There has been a remarkable shift in sentiment at major institutions like the IMF, the OECD, central banks and the European Commission. Whatever the choice of words, the message is now unanimously in favour of pursuing structural reform and adopting more pro-active fiscal policies to stimulate growth.
The reasons for the policy shift
Normalisation or "new normal"?
Since the 2007-8 financial crisis in the US and the subsequent tension in Europe in 2010-12, growth has been modest and irregular. The situation in emerging countries has been very varied. Countries like India and Vietnam have enjoyed robust growth while many others, which are dependent on conditions in China, have suffered from the economic slowdown there. In return, developed country exports to emerging countries have been hit. Commodity price drops in 2014 and 2015 have also fuelled deflationary pressure throughout the global economy.
Adopting different or complementary measures
Is the current cycle part of a ‘new normal’ or is it just a (rather peculiar) phase in a classic economic recovery? The ‘new normal’ theme has been much in vogue since the financial crisis and has featured strongly in the debate over ‘structural stagnation’ and weak productivity gains.
Although the debate on deflation has become less acute, price inflation is still running below central bank targets. Along with liquidity injections, lowering interest rates has been one of the preferred tools deployed by monetary authorities. Today’s situation is, in fact, part of a downward trend in nominal yields which has been in place for more than 30 years, but negative nominal yields are unprecedented. Real interest rates have also been falling over the long term with occasional passages into negative territory.
Following central bank efforts to stimulate monetary as well as economic growth, the question today is whether to adopt different or complementary measures. The US Federal Reserve would like to restore some room for manoeuvre. Its initial rate hike in December 2015 was meant in part to kick off a move back to normal interest rates.
This is not currently a concern for the ECB but the bank is fully aware of other, equally fundamental, issues. Current nominal rates risk jeopardising bank profitability. And above all, they risk destabilising retirement schemes and insurance companies.
The limits of a low interest rate environment
Persistently low, or even negative, interest rates are not just bad news for financial schemes. Lower returns on savings also reduce household incomes. And they can even, paradoxically, push some households into saving more so as to offset the fall in their revenues from sources like bank accounts and bond holdings.
Demand-side policies are no longer a taboo
A certain number of countries, acting alone or in concert with others, have already decided to change tack for 2017. US budgetary policy will certainly be more expansionist with Trump. In Japan, Shinzo Abe’s administration appears determined to launch a fresh economic stimulus plan. And even in Germany, government spending has already increased, albeit with a balanced budget. Tax cuts are also being considered. Elsewhere, getting deficits lower is no longer a priority and governments are now well aware of the electoral price to pay for fiscal discipline.
More generally, positions have been shifting due to the pressure of populist camps and the political aftershock from the UK referendum. The coming months will be risky for markets due to a heavy electoral agenda but it is remarkable that almost everyone in the political spectrum, whether they be liberal, social democrats or populists, is in favour of less rigour even if solutions proposed may differ radically between lower income or corporation tax or higher government investment.
Attractive funding costs
One of the most spectacular consequences of unconventional monetary policy has been the fall in nominal interest rates to very low, and even, negative levels. Europe is a good example. As early as June 2014, the ECB took the rate it pays on bank deposits into negative territory. It currently stands at minus 0.4%. And over 18 months, the ECB has purchased more than EUR 1 trillion in bonds.
Sovereign debt yields are at historic lows everywhere, but the situation in the eurozone and in Japan is exceptional. Yields on German bonds are negative across most of the yield curve. And the picture is even more remarkable if we focus on real yields: even in the US and in Italy, they are negative or close to zero for maturities below 10 years while the entire yield curve is well into negative territory not only in Germany and Japan but also in France and the UK!
In France, which issued debt at an average rate of 0.37% for the first nine months of the year, down from 0.63% in 2015, annual interest payments on outstanding debt of EUR 2,170 billion at end September came to EUR 44.4bn, the fourth largest item on the government’s budget. This is therefore not only a question of good accounting but concerns the very means of government action. This year, France managed to issue 50-year bonds but the average maturity of its long-term debt is more than 7 years.
What is the best balance?
Unlike monetary policy, fiscal policy has a direct impact on the real economy by stimulating demand for goods and services. The speed of the economy’s reaction depends on which instruments are used. The big problem facing government investment is the time needed to roll out measures. At the same time, current government expenditure is still being scrutinised as ageing populations will mean higher healthcare and retirement needs. This puts spending under constraints but the tax tool is always available and that is where flexibility can come into play. But more accommodating budgetary policy does not necessarily entail an increase in government investment. It can also take the form of lower income or corporation taxes as long as a government’s actual budgetary policy looks credible. If not, economic players will probably react by boosting their savings rates.
By playing on the extent of social contributions and how they are raised, governments can in theory solve deficit problems in a contra-cyclical manner. Unemployment levels can act as a gauge before contributions are raised or lowered. In practical terms, even if forecasting is tricky and caution is the watchword, tax is the most flexible tool for governments looking to regulate the cycle.
The US example is particularly interesting even if the 2016 Presidential elections have created some uncertainty over the shape of the 2017 budget. The US government deficit has fallen from 10% of GDP in 2008 to around 2.6% in 2016. And real growth in federal and local government spending has moved from negative to moderately positive territory. The needs are huge and meeting them cannot be indefinitely postponed.
More broadly, the focus should be on decisions which are likely to increase a country’s particular growth potential, even if governments have rarely been experts in forward thinking.
What might result from rebalancing policy mixes?
A new balance between monetary and budgetary stimulus should go down well
Given the flaws in the preceding economic policy regime, a new balance between monetary and budgetary stimulus should go down well. But there are a number of uncertainties and everything has to be redefined. Central banks and governments have rarely had to contend with such a sweeping overhaul of their measuring instruments. And countries are dealing with different and even diverging situations.
Are we about to move from excessive budgetary discipline to excessive stimulus? This will depend on how quickly the budgetary approach accelerates and to what extent monetary policy applies the brakes, a combination which is difficult to define. The effects of monetary stimulus will not evaporate as they are by nature staggered while a different budgetary bias will immediately stimulate demand, and with a multiplier effect to boot. Both movements will therefore run at different speeds but in any case monetary policy adjustments can never be brutal.
Monetary policy adjustments can never be brutal
The situation in each country is different. The US Fed wound up its bond-buying programme 2 years ago and has already proceeded with one rate hike. Its chair, Janet Yellen, has nevertheless said on several occasions that the future pace of rate hikes would be the most moderate in 30 years. The ECB, on the other hand, will have trouble realigning policy even if European governments adopt different budgetary policies.
The biggest risk, as the IMF and BIS have regularly pointed out, is financial instability. We have seen several examples of this, notably in 2013, when emerging countries were hit by severe currency market disruption and a rise in their cost of capital. Financial conditions and market liquidity can trigger tension. The behaviour of financial market players adapts long before the emergence of concrete economic results.
Moreover, central banks can now more easily influence the yield curve. As Eric Rosengren, the chair of the Boston Fed recently pointed out, the FOMC can help steepen the yield curve by selling long term bonds and buying short term debt and with no change to Fed Fund levels or the size of its balance sheet.
Note, however, that the G4’s unconventional policies will create a new risk for central banks over time. QE can, in effect, be seen as a gigantic exercise in transformation which is funded over the very short term at the central bank’s benchmark rate but in return reaps the average yield of the bonds the bank has bought. If, at some future date, the bank were forced to raise its benchmark rate above the yield on its bond portfolio, it would be making an accounting loss which could damage its independence.
There is also the additional risk of pushing government debt even higher than today’s lofty levels. Many countries have debt levels flirting with, or exceeding, 100% of GDP (France is at 98.4% and Germany at around 80%). But the debt to GDP ratio is less relevant than that of debt servicing as a percentage of GDP and that measure has fallen sharply in all developed countries. In the US, it represents less than 3% of GDP and less than 2% in the eurozone. Moreover, given the structure of the debt, this cost is moving in line with the moving average of the market’s rate over the average life of the debt. In France, for example, we should be comparing 7 year rates, currently around zero, to the 7-year moving average which is running at approximately 1.5%. This means that rates would have to rise by more than 150bp for the average cost of debt to begin rising in 2017!
Lastly, when growth accelerates, it is hard to predict how prices will behave. In spite of the long period of disinflation we have seen, the trend has occasionally been interrupted by price rises. In the US, wages are seeing a modest acceleration -without any tension on costs- and price inflation is not that far off Fed targets. If inflation causes interest rates to rise without any tension on real rates, the debt to GDP ratio, which is sensitive to nominal growth rates, will move in a favourable direction.
The monetary tool, i.e. measures involving liquidity, interest rates and asset purchases, has long been the essential arm in the effort to underpin economic growth. This period is perhaps coming to an end. The credibility of central banks has from time to time been threatened, but their actions have had positive consequences even if their effectiveness has been waning.
This is why government spending funded by bond issues could take over in coming years. At the moment, there are some grounds for scepticism over the scope of possible measures and how they might be rolled out. But there are so many signs of a change that we can no longer overlook developments. The change that is taking place is not only a shift in rhetoric.