Search this website. You can use fund codes to locate specific funds

Rising recessionary risks shifts focus to fiscal fallback options

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.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.

Latest Articles

UBS, Federated Investors, Inc. and Hermes Investment Management Launch Innovative Fixed Income Impact Funds
Federated Investors Inc., Hermes Investment Management and UBS today announced the launch of new SDG Engagement High Yield Credit funds
Q4 Economic Outlook: learning to live with deflation...
In his latest Economic outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues that Japan-style deflation is becoming an increasing possibility elsewhere.
Not all ships are rising on the tide
In the latest 360°, Hermes’ Fixed Income Quarterly Report, Andrew Jackson, Head of Fixed Income at Hermes Investment Management, explores how investors can navigate the growing negative-yield credit landscape.
Ecommerce in Russia – a moonshot in the making?
Russia’s ecommerce industry is a rare gem within the troubled wider economy.
A protectionist tsunami is driving a new world order
Is the trade war disruptive, or is it merely accelerating trends already underway?
What does the pound's poor week suggest for future performance?
Sterling has had a rough ride over the last few weeks, hitting a 33-month low – against a trade-weighted basket of currencies – on Tuesday 30th July. Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, looks at the downward pressure on the pound that has been driven by increasing odds of a no-deal Brexit following the installation of the new UK government led by PM Boris Johnson.

Press Contacts

Melanie Bradley, Head of Investment & Stewardship Communications
Rachael Dowers, Manager - Investment and Stewardship Communications
Hannah Bellfield, Assistant Manager - Corporate Communications
Harriet Hall, Associate - Corporate Communications