In recent times, bond yields in the US, the European Union (EU), and the UK have reached their highest levels in 15 years, despite a decrease in retail inflation. This peculiar scenario can be attributed to the bond market’s anticipation of further future inflation reduction. Additionally, home loan rates in the US and the UK are nearing their highest recorded levels from last year. These developments reflect the increasing possibility of excessive monetary policy tightening due to limited fiscal space, as previously mentioned. However, it is worth noting that countries like Japan, China, and India, with relatively fewer fiscal interventions, seem to face less severe problems. The looser fiscal policy in the US also explains why the anticipated economic slowdown has not yet materialized.
Fiscal Policy and Inflation
For several decades, economists have emphasized the relationship between fiscal policy and inflation. Notably, in 1981, Sargent and Wallace discussed this connection in their paper titled “Some Unpleasant Monetarist Arithmetic.” A recent study by the Bank of International Settlements reinforces the link between fiscal policy and inflation. According to the study, a one percentage point increase in the fiscal deficit can raise inflation by 10 to 50 basis points over a two-year period. The impact is more pronounced in a regime driven by fiscal policy, where the government pays little attention to debt stability, and monetary policy lacks concrete measures to restore price stability.
The Role of Fiscal Prudence
In contrast, when greater fiscal prudence is adopted, such as targeting a stable debt-GDP ratio, and monetary policy enjoys more flexibility, higher fiscal deficits have a lesser impact on inflation. Unfortunately, out of the 21 advanced economies studied by the Bank for International Settlements in 2011, only one demonstrated efficient fiscal policy. Presently, prevailing policies in rich economies indicate worse outcomes, according to the given definitions.
Fiscal Deficits in Developed Economies
The International Monetary Fund (IMF) predicts that the fiscal deficit in developed economies could reach up to 4.4 percent of GDP this year, surpassing the 10.2 percent of GDP recorded in 2020. This would mark the highest level since 2012 (excluding the Covid-impacted period). As interest rates rise, the government’s debt increases, and the primary deficit (fiscal deficit minus interest payments) is not expected to decrease significantly in the foreseeable future.
Contrasting Policies with the 2008-09 Crisis
Current policies differ from those implemented after the 2008-09 crisis when developed economies opted for flexible monetary policies and tighter fiscal measures. The unintended consequences of these policies, such as delayed job market recovery and increasing wealth inequality from financial asset costs, likely influenced a shift in approach. In the US, wage growth for the lower income quartile has outpaced that of the top quartile, and unemployment rates have decreased among less educated and economically vulnerable communities. Consequently, there is no immediate political motivation to quickly restore fiscal consolidation, as projected by the US Congressional Budget Office.
Implications for the Future
This situation has two important consequences. Firstly, it emphasizes the need to consider forward-looking indicators of fiscal policy beyond just inflation trends. Secondly, global monetary policy may remain accommodative for an extended period. Since interest rate effects depend not only on their peak levels but also on their duration, the expectation is that interest rates are nearing their highest points.
Financial Asset Valuation and Debt-GDP Ratio
The decade prior to the Covid pandemic witnessed fiscal consolidation and monetary policy easing, which boosted the value of financial assets. Consequently, the global wealth to GDP ratio increased from 3.7 percent in 2012 to 4.9 percent. However, an extended period of high interest rates can lead to a decrease in this ratio, posing new challenges for economic growth and stability. Insufficient fund availability can weaken risk appetite and create an asset-liability mismatch.
Policy Implications and Global Effects
Divergent policy approaches will have unintended consequences on other economies worldwide. Easy monetary policy benefits countries with high current account deficits that rely on foreign capital. Continued fiscal stimulus will particularly benefit countries with a trade surplus with the US. On the other hand, prolonged monetary tightening increases risks for slightly more developed and fast-emerging economies in terms of loan default.
The Future and Potential Concerns
Looking ahead, several concerns may arise. There could be growing mistrust regarding US bonds, although the lack of a reliable alternative to the dollar currently prevents serious consideration. However, persistently high interest rates could strain solvency principles. Some experts believe that an increase in inflation-induced nominal GDP, driven by rising inflation, could lower the debt-GDP ratio. Nevertheless, projections indicate that this ratio will continue to rise over the next decade due to increased interest payments, even if the primary deficit remains stable in the US. In Europe, the debt-to-GDP ratio has decreased compared to 2021 but remains elevated compared to the pre-Covid period.
Conclusion
The relationship between fiscal policy, inflation, and bond yields holds critical implications for global economies. The recent rise in bond yields, coupled with ongoing fiscal deficits, points to the need for careful consideration of future indicators beyond inflation alone. Moreover, global monetary policy may remain accommodative, particularly with interest rates approaching their peak levels. As economies navigate these challenges, policymakers must strike a balance between fiscal prudence and sustainable growth to maintain economic stability.
