For over a decade after the financial crisis central banks appeared to be the only game in town. While fiscal policy was focusing merely on consolidation, central bankers like masters of the universe were pushing monetary policy to its limits in an attempt to combat anaemic growth and low inflation: slashing interest rates to at or below zero, and spending trillions on quantitative easing asset purchases. The balance sheets of the central banks in the euro area, UK and US swelled sevenfold, from 20% of GDP to over 140%.
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Things changed with the pandemic, when it was the turn of fiscal policy to go into overdrive as governments chose to shut down large swathes of their economies. The year 2020 saw an unprecedented five percentage-point fall in the cyclically adjusted primary balance (a good proxy for discretionary fiscal stimulus) of the advanced economies. Since records began in 1990, the largest previous such spending — during the GFC — amounted to less than two percentage points of GDP.
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Inflation was revived by this sugar rush of stimulus, alongside a sudden shift towards the consumption of goods rather than services. Price pressures increased across the board, eventually forcing a rapid increase in central bank policy rates. Long-term interest rates also increased, albeit not by as much. So far, this has been helpful to control inflationary pressure. But it has also meant higher interest rates, and expectations that they will stay higher for longer. Two-year real interest rates (nominal rates discounted by nominal inflation) have increased by several hundred basis points over the past few years.
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Today in many economies there are calls for greater government intervention: to help decarbonise the economy, to increase military spending and to engage in a more active fiscal policy. But the backdrop of high debt levels and higher interest rates makes bold government harder to achieve than it would otherwise be. The UK’s incoming Labour government has increased borrowing by £32 billion per year, with £70 billion in increased spending only partly funded by new taxes. Across the pond, researchers at the University of Pennsylvania expect the second Trump administration to increase borrowing by $4.1 trillion over the next decade. If correct, that would keep budget deficits at historically high levels, with only the GFC and COVID recessions leading to larger borrowing as a share of GDP.
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Borrowing of this type can help to boost economic growth; but when output is judged to be at potential, there is a risk that large government outlays will simply displace private economic activity and push up inflation instead. There was more scope for pro-growth fiscal stimulus in 2016, when interest rates, inflation and the interest on government debt were all generally lower; the question is more nuanced this time around. Fathom has previously described the Federal Reserve and US Treasury as being in a tug of war — now it seems the fiscal authorities have added some well-muscled team members to haul on their end of the rope. How the Fed responds remains to be seen.
Large investments in R&D are much more likely to ‘crowd in’ private sector investment, not only boosting medium-term growth rates but keeping inflation more in check. However, income tax cuts of the sort that have been mooted by President Trump are likely to add additional demand to an already strong economy. Private consumption has been growing at an annualised rate of 3% over the past year.
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In the near term, the main impact has been a repricing in interest rates, with the ten-year US treasury yield increasing by more than 50bps in September as the implied odds of a Trump election victory became increasingly priced in. These sorts of levels are not yet a source for huge concern. Indeed, by forcing barely profitable firms out of business they may help what has been a strong productivity performance in recent years.
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The bigger risk is over the longer term. Even before any impending tax cuts, the Congressional Budget Office expects US federal debt to rise inexorably. Net interest payments are already expected to cross $1 trillion next year and approach $2 trillion within a decade. It seems hard to imagine the US, with the world’s reserve currency and the ability to print money, undergoing a hard default. But so long as appetite for fiscal consolidation remains seemingly limited on either side of the aisle, and while structural forces continue to add to budget pressures, investors may seek an increased risk premium on US government debt, while moving more of their wealth into assets that could protect it from higher inflation. With President-elect Trump due to serve just one more term, that sort of outcome may be a future president’s problem.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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