Policymakers are changing their tone on fiscal policy. More governments are now looking at fiscal support, and the focus on austerity has faded as monetary easing reaches its limits.
The shift away from austerity and the acknowledgement of the need for fiscal and monetary coordination matter for financial markets. In our inaugural Global Macro Outlook, we assess the potential for more fiscal easing in key economies, and gauge the impact on global growth and asset prices.
The potential for fiscal easing
Governments in major economies are reconsidering austerity. They’re considering spurring growth via fiscal easing, as the global recovery struggles to gain traction despite years of monetary easing.
Behind the shift: Central banks are reaching limits, with rates testing the lower bound. Also, a lack of fiscal support may undermine the effectiveness of monetary easing, as argued in a 2016 paper by Nobel Prize-winner Chris Sims. Without the public and private sector taking advantage of easy financial conditions, low rates can hurt savers and foster deflationary forces.
Beyond continual disappointments in global growth, the need for public investment is stark. The average age of U.S. public infrastructure is the highest since at least 1950.
Just some of the signs of the shift: Infrastructure spending features in the U.S. presidential campaign. Japan and Canada have pushed ahead with public investment. The UK appears set to temper its fiscal consolidation.
The International Monetary Fund (IMF) has become a bigger champion of fiscal expansion, while the G20 committed in September to “greater policy coordination and deploying more growth-friendly fiscal policy.”
The potential impact on global growth and asset prices
This changing tone is unlikely to equate to an immediate acceleration in growth, and some big developing countries such as Brazil are tightening their belts. But economists are upgrading their forecasts. See the chart below.
We believe fiscal policy must take the baton from central banks to shore up growth. We favor measures that have a positive impact on long-term growth. There is never a case for reckless fiscal spending, but productivity-enhancing fiscal expansion, such as infrastructure investment, is likely to be more effective than usual, in our view.
Historical evidence suggests, an increase in the budget deficit tends to boost overall activity by the same amount (in dollar terms). This implies a fiscal multiplier close to 1. But the multiplier varies over the economic cycle—higher during recessions or when short-term rates are near zero, and lower when an economy runs near fully capacity.
Yet this is not your usual environment. Monetary policy is constrained and with global excess capacity, public investment is less likely to crowd out private investment. We believe fiscal policy should be more effective, and thus the multiplier higher than the historical average.
We estimate that the major economies’ expansionary plans in isolation (and excluding China and other emerging markets) could provide a cumulative boost of around 0.3% to world gross domestic product over the next two years. Using more optimistic assumptions about the fiscal multiplier effect and spending plans, we could see this rising to 0.7%.
We see the various fiscal expansion measures leading to rising primary structural budget deficits in the developed world, particularly in the United States. We do not expect a big jump, to be sure. But a return to rising deficits would mark a sea change. As the chart below shows, we see the shift to bigger fiscal spending among G7 economies now making a small contribution to global growth rather than subtracting from it, as the IMF still forecasts.
What is the impact on asset markets? Long-term yields typically rise on fiscal expansion, but central banks still have the intent and ability to limit any unwanted increase in yields.
Fiscal expansion could lead to FX appreciation. Yet we see little fallout on currencies for now due to the likely muted change in bond yields. Equities will likely receive mild support from stronger overall demand, with distinct impacts for some industries.
The shift from austerity to fiscal spending matters, even if the short-term growth implications will be limited. The current focus on fiscal expansion is likely just beginning.