What policy space is left to sustain economic recovery?

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With the magnitude of policy loosening adopted to counter the fallout from Covid-19, many are wondering what economic policy options are left, both if further stimulus were to be required in the near future – and to advance those medium term goals that were high on the policy agenda prior to Covid-19.

The Covid-19 crisis has struck against a backdrop of slow global growth, low inflation and interest rates, and elevated debt burdens, exposing these pre-existing vulnerabilities further.

Government debts are now projected to rise to post World War II highs: more than 120% of GDP in advanced economies and more than 60% in emerging markets in 2020 (IMF – Fiscal Monitor April 2020). Central banks in advanced economies have already set policy rates to zero or negative levels and massively expanded their balance sheets, which now total 60% of GDP in the US, Euro area and Japan in aggregate.

We can think of policy space as the maximum amount of fiscal and monetary stimulus that policymakers could provide in response to an adverse shock, given the full range of existing policy tools. But an assessment of policy space in these terms would be incomplete.  New policy tools could be introduced without substantially changing existing policy frameworks. And policy frameworks could be changed.  

In addition, any assessment of policy space is more complex than simply calculating how far policymakers can pull their policy levers. There are hard constrains, e.g. the amount of assets to purchase under Quantitative Easing (QE), and softer constrains which require trade-offs, e.g. risks to financial stability or political concerns.  Finally, there are complex and non-linear interactions between monetary policy and fiscal policy, which can change the quantification of policy space:

  1. Monetary and fiscal policy can be good complements, particularly when monetary policy is at the lower bound, as the size of fiscal multipliers is significantly higher when interest rates are low.
  2. Monetary and fiscal policy are not substitutes (for example monetary policy cannot solve ‘real’ problems, such as slow productivity growth).
  3. Monetary policy response to shocks can limit the amount of fiscal policy space, particularly if interest rates are raised above nominal growth when the level of public debt is high.
  4. Fiscal policy can limit the amount of policy space for monetary authorities, for example if an increase in public debt can raise questions about the sustainability of the debt load and requires policy rates to be increased to limit any capital flight.
What policy space is left given existing tools?

Given how low interest rates are and will likely be in the future, conventional monetary policy (i.e. policy rates) appears to be the one most obviously constrained in what it can do going forward. In response to the Covid-19 shock, central banks have adopted existing and new unconventional policy tools, expanding the range of assets purchased under QE and engaging in a number of new credit easing policies. These policies will most likely remain part of the policy toolkit, albeit not all will be used in more ‘normal’ circumstances given the amount of risk involved (for instance, direct lending to businesses). Asset purchases and forward guidance will be the marginal tool for loosening the policy stance in the near term. Taking the Bank of Japan (BoJ) as a benchmark for how far asset purchases can go in proportion to GDP (more than 100%), the Federal Reserve, the European Central Bank (ECB) and Bank of England still have significant room to go¹, at least in theory. In practice, hard and soft limitations may bite much earlier in these three regions, including worries about central banks’ independence and institutional constraints.

The IMF defines fiscal policy space as the room for undertaking discretionary fiscal policy relative to existing plans without endangering market access and debt sustainability. Absolute debt-to-GDP levels alone are not the determinative factor for debt sustainability. For example, Japan, with general government debt at more than 230% of GDP prior to the Covid-19 crisis, pays among the lowest rates in the developed world, with no compensation for credit risk required by investors. As such, fiscal policy in advanced economies will not necessarily be constrained by public debt levels already at 100-130% of GDP.  That said, prospects for growth and interest rates are central in any assessment of debt sustainability. In many countries, the sustainability of current debt loads hinges to a significant extent on interest rates remaining low for the foreseeable future. Relatedly, the ability to set monetary policy autonomously is also a key factor that increases fiscal policy space.

Fiscally-sound countries, with autonomous monetary policy, sound institutions and policy frameworks, and access to large and sticky pools of savings, are likely to be retain a significant amount of policy space. These include the US, Germany and Japan. Countries with significant current account deficits, such as the UK, or the inability to set its own monetary policy, such as Italy, will likely remain more constrained.

What new policy tools could be introduced without substantially changing existing policy frameworks? How could existing policy frameworks be changed?

To tackle long term challenges, fiscal policy will need to become more proactive. In a context of low inflation, a lack of conventional monetary policy space, and high debt burdens which make it hard to sustain higher interest rates, it’s quite possible that central banks will introduce new tools to limit the increase in nominal rates and raise inflation expectations, therefore reducing real rates and keeping them substantially below real growth rates. Some version of reinforced forward guidance or yield curve control (similar to what was seen in the US in the 1940s and early 1950s or what Japan is doing today, where central banks cap short-term and long-term interest rates to produce low yields with an upward-sloping yield curve) is therefore likely in the US and potentially in the UK. This may be challenging in the Euro area as there are 19 different yield curves, and it would not constitute much additional policy easing in Japan. It’s also possible that there will be the introduction of a new strategy for inflation, characterised by the accommodation of higher inflation (for a limited period of time and up to a certain level) to make up past shortfalls of inflation from target. Given the more severe lack of policy space, the Bank of Japan is the central bank more likely to be experimenting with novel policy tools going forward.

Longer term, the amount of policy space will depend on how successful economies will be in raising long term growth and inflation. Ultimately, if these remain low or worsen from current lacklustre levels, it’s not possible to rule out the possibility that advanced economies will change existing policy frameworks – broadly defined as characterised by a sound fiscal framework, low and stable inflation, stable growth and central bank independence. We do not see this as likely at the moment. But as the Covid-19 crisis has highlighted, future shocks and the related policy response remain to some extent unpredictable. Here are some possible outcomes:

  • Policies may include more extreme changes in the policy target, such as a higher inflation target (e.g. at 4%, as some have proposed), or nominal GDP level targets.
  • There could be a more explicit coordination between fiscal policy and monetary policy, and at the extreme, some type of deficit monetisation.
  • Assuming a benign management of high fiscal burdens becomes impossible, countries would be left to choose among a number of unpleasant policy options, ranging from debt monetisation by the central bank to debt restructurings and defaults. This may eventually restore policy space in the longer run.

More radical changes to the policy framework are likely not to take place without significant downsides. These may include the risk to central bank credibility and, to the extreme, to central bank independence, a re-indexation of the economy and high inflation, a loss of credibility for fiscal authorities and the build-up of a significant credit premium for domestic assets.

¹They all have purchased less than half in proportion to GDP than the BoJ.

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