It's scarcely possible to read about global economic policy these days without hearing that central banks have run out of ammunition and a call to open the fiscal floodgates. But is fiscal policy really the answer to whatever is ailing the global economy? And has the great monetary experiment really reached the end of the road? We think not.
We’re willing to concede that expansionary fiscal policy – more public spending – will lead to stronger economic growth when the policy is active, and that fiscal stimulus is likely to have a more direct and immediate impact on output than monetary stimulus. There are still question marks surrounding magnitudes, of course, but a switch towards a more active use of fiscal policy should therefore be positive for global growth, at least in the short term. But there are important caveats.
Most proponents of fiscal expansion still look at it through a conventional demand-management or business-cycle lens, in which a quick dose of stimulus is enough to push the economy back onto a “normal” path. And fiscal fine-tuning of this type would be the right medicine if we were facing a conventional business-cycle recession.
But what if economies face more persistent headwinds, such as the deleveraging phase of a debt supercycle or secular stagnation – a period of very low or no growth which is not cyclical or short term? Under those circumstances, a temporary burst of fiscal stimulus is unlikely to help much, and growth is likely to slip back once the stimulus has worn off. Ultimately, fiscal policy might be viewed with the same disdain as QE is today.
That’s where the idea of permanent fiscal stimulus comes in. Nobody has grasped this nettle yet, though Japan has come closest. However, this would require permanent support from monetary policy, which brings us to a crucial point. Fiscal policy should not be seen as an alternative to monetary policy but as working in concert with it: “joined at the hip”, as we like to call it.
This raises another important question: does monetary policy support fiscal policy, or should we think about it the other way around? In other words, is fiscal policy a way of channelling monetary stimulus into the real economy instead of asset prices, as has been the case with QE? More and more, we think this might be the case, or at least that the distinction between monetary and fiscal policy is blurred.
It’s through this blurred lens that we should consider the Bank of Japan’s latest actions, which strengthened the delivery of monetary stimulus in several key ways. Beyond the eye-catching introduction of explicit yield-curve targeting, which will see the central bank buying bonds to keep 10-year yields at about 0 per cent, two particular aspects of “QQE with Yield Curve Control” stand out.
First, the BoJ is committed to continue expanding the monetary base until inflation is above 2 per cent and set to stay there. This new “inflation-overshooting commitment” means the BoJ has implicitly raised its inflation target: 2 per cent is now the floor, not the midpoint. The aim here is to reset inflation expectations at a higher level, without which the BoJ will struggle to create permanently higher inflation – as the European Central Bank is also starting to discover.
Second, the BoJ has explicitly recognised the need for policy coordination. It said in September that it “believes that its monetary policy and the government’s fiscal policy […] will produce synergy effects, and thereby will navigate Japan’s economy toward overcoming deflation and achieving sustainable growth”.
Part of that policy coordination is about monetary policy anchoring bond yields and giving fiscal policy more room for manoeuvre. But, as noted earlier, coordination can also work the other way. Fiscal policy can act as a channel to ensure that money created by the central bank is directed at spending on goods and services and therefore more likely to create traditional inflation, particularly against a backdrop of tight capacity, as is the case in Japan. Moreover, permanent fiscal stimulus would have a powerful impact on inflation expectations, especially if it’s made explicit that any deficits will be monetised.
Despite the growing clamour for a more active use of fiscal policy, we’re sceptical that conventional fiscal stimulus will act as anything other than a short-term palliative. But if implemented on a sufficient scale (in terms of magnitude and duration), there’s every reason to believe that joint monetary and fiscal stimulus will lead to a sustained rise in inflation. It’s just a question of who’s going to try it first? Unsurprisingly, our money’s on Japan.