Monetary policy – which did the heavy lifting in the aftermath of the global financial crisis – has reached its limits. As central banks will be unable to provide the same amount of stimulus that they deployed during previous crises, the next downturn will call for a fiscal response. However, in her latest note, Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, also argues that in a fragmented international landscape, global economies would struggle to deliver a coordinated response to a recession through either monetary or fiscal means.
The US is in a mature phase of the business cycle
As the current US expansion hits its 10th birthday, signals about the outlook have been mixed. Recent US economic data has been solid, with Q1 GDP surprising to the upside and solid employment growth. However, consumer and business surveys – which are running at elevated levels – have shown cracks in recent months.
The US’ expansionary fiscal stance has undoubtedly supported economic performance over the past 12 months, but this effect is likely to fade, particularly in the second half of 2019. At the same time, following the Fed’s dovish turn at the beginning of this year, monetary policy looks set to remain fairly accommodative. However, the US yield curve is now flashing amber with respect to recession risks. The inversion of the yield curve at the end of March pushed the New York Fed’s recession probability to almost 30%, a high within the current cycle.
The longer the current accommodative setting for monetary policy lasts, the easier it is for financial imbalances to build up. In turn, this implies that the financial system is more vulnerable to even small shocks. Further escalation of US-China trade tensions and the potential contagion into other economies threatens to tip an already vulnerable system into a recession.
Monetary policy: options exhausted
Today, we are navigating the late-expansion stage of the business cycle, in which the space for monetary policy is extremely constrained. Worryingly, central banks have little ammunition to respond to the next downturn.
Nominal policy rates globally have been trending downwards in recent decades; they are now running at levels that are low by historical standards and close to their lowest limit, the so-called effective lower bound (ELB). In a world where it is possible to hold cash, the ELB is around zero or slightly negative. In order to adopt an accommodative monetary policy stance, central banks need to set their real policy rate below the equilibrium real rate – the interest rate that keeps the economy operating on an even keel – the so-called r*.
During the next recession, central banks will be unable to provide the same amount of stimulus that they deployed during previous crises. They will not be able to move the real policy rate significantly below a low r* by cutting nominal interest rates – and they will hit the ELB more often. Low inflation expectations can be deemed as another constraint, as they imply that the floor for the real interest rate is higher than it should be.
Unconventional monetary policy tools also look less attractive than in the recent past. Negatives rates – currently deployed across the eurozone and Japan – could damage banks’ profitability. Quantitative Easing has shown diminishing marginal returns, while also contributing to higher wealth inequality. As such, the response to the next downturn may need to come from fiscal policy.
Fiscal policy: the only fallback
After years of intense focus on monetary policy, discussions about the appropriateness – and even desirability – of large fiscal deficits has taken centre stage. In particular, the fact that interest rates are running below nominal growth rates in the US and most developed economies implies low fiscal costs of higher public debt. In the current configuration, there is a case to use public debt, notably to fund productivity-enhancing spending, such as the funding of public infrastructure projects.
However, public debt as a share of GDP is already high across developed countries (at almost 100%), suggesting that the space for fiscal stimulus is limited. Further, while accommodative monetary policy is keeping rates low, high debts might lead to higher interest rates, particularly if financial markets come to doubt their sustainability.
That said, monetary and fiscal policies face other challenges. To be effective during a financial crisis, international coordination is necessary. However, in an increasingly fragmented international landscape, in which the fortunes of multilateralism are falling, it is unclear whether the response to current and future global challenges and crises will be effective.