Paul Diggle 00:06

Hello, and welcome to macro economics and politics podcast from abrdn. My name is Paul Diggle Deputy Chief Economist at abrdn, and today I'm joined by Luke Bartholomew, co host of the podcast. And today we're talking about the outlook for monetary and fiscal policy in the coming recession, especially in the context of the US, the UK in Europe. And we've spoken a few times on the podcast about why we are forecasting a global recession. And that call has, indeed, I think, become much more consensus over the past few months as the drivers of the recession have become more evident. But now we want to move the analysis on a step further and think through what monetary and fiscal policymakers should and will do, because those might be different in that recession. And that, of course, has wide ranging implications for financial markets as well. So is it back to negative rates and quantitative easing? Or will persistent inflation mean that interest rates remain high, even as recession hits? And on the government side do is fiscal policy spend big to support the economy or our governments constrained by what markets will fund and what governments can afford? So a lot to discuss. Let's get into it, Luke? So I've spoken there about the coming recession, but really, there are at least two, maybe three distinct shocks hitting the global economy, the energy price shock, in Europe, the monetary policy tightening in the US, how do those different drivers of recession affect what an optimal fiscal policy response would be?

Luke Bartholomew 01:54

Sure. Thanks, Paul. So the first order effect of a change in fiscal policy is that it does have some impact on aggregate demand in the economy. So easing fiscal policy, which is to say cutting taxes or increasing government spending tends to boost aggregate demand, all else being equal, and vice versa for tighter fiscal policy. Now, that's not to say that fiscal policy doesn't have an impact on aggregate supply, it absolutely does. Changes in what the government invests in how much it invests the way in which taxes incentivize or disincentivize, certain behaviour will invest in their spending decisions work. Ultimately, a lot of these have to be pinned down the productivity in the economy. But those kinds of fiscal decisions that affect those things tend to play out over a much longer time horizon. So you might think, on the basis of that, that fiscal policy has an important role to play in stabilising demand in the economy. And certainly, it does have a role to play in the sense that it sort of there are automatic stabilisers that tend to work so that when the economy is in a downturn, fiscal policy tends to automatically ease through increased spending on say, unemployment benefits and other welfare payments. And vice versa. As those things get turned off, as the economy improves, and fiscal policy tightens, then so it does tend to have this sort of automatic stabilising role. But in the current division of labour, as it were, between the different policy levers monetary and fiscal policy, our current setup tend to that much more weight on the role of monetary policy as the key demand stabilisation tool. And there are at least two good reasons for that. The first of which is given what I was saying about the role in which fiscal policy plays in determining supply side policies in the economy, but also the important role it has in redistribution and other priorities that the government might have sort of changing fiscal policy in response to demand conditions might upset those kinds of things. Or it's better if there was long term stability around those questions. And second, because questions of government spending and taxation are inherently very political, that tends to be quite a convoluted political process that has to be gone through before there can be a change in fiscal policy. And so in that sense, might make it less nimble and adapting to changing demand conditions. So that's why we tend to think monetary policy which can respond more quickly with changes in interest rate are more appropriate. However, there is one huge exception to this and that's when monetary policy is constrained. That is to say, it's unable to provide as much support to the economy as would be optimal, which is typically the case when interest rates get stuck at the effective lower bound to interest rates can't be pushed, any lower and unconventional policies might have less traction on the economy. In that case, it absolutely is optimal policy for fiscal policy to be involved in also boosting demand

Paul Diggle 05:02

so that that framework of differentiating a supply shock versus demand shock strikes me as absolutely crucial because Europe shock is first and foremost, a negative supply shock that can but make you poor in some way and fiscal policies role is to, to redistribute and protect the most vulnerable in that situation. And ideally, without doing outright stimulus that makes the inflation pressures worse. And then the US has cases, perhaps something akin more to a demand shock, or at least, but one deliberately engineered by the central bank to reduce inflation, of course. And we think, right, Luke, that that zero lower bound episode, and we'll get onto this could strike in the US. And that gives a lot more scope for fiscal policy to take up some of the slack.

Luke Bartholomew 05:55

Exactly right. But then that raises the question outside of optimality, what kind of policy actually ends up being delivered. And as we are recording, today's the date of the US midterm elections. And so while we don't know the results of that, I think it's pretty clear that those results will have important implications for the kind of fiscal policy that the US is able to employ next year in the course of this recession that we're expecting. Indeed, it looks pretty likely that the Republicans will take at least one house of Congress, if not both, and that means divine government, and therefore, much more difficult when a downturn comes to pass any sort of meaningful fiscal stimulus partly because the Republicans are at some level ideologically opposed to using fiscal stimulus in those kinds of circumstances, partly because it's very difficult to get cross party agreement on the kind of taxes that should be kept on the kind of spending that should be prioritised. And also, partly because I suspect there is at least some part of the Republican party that's quite happy to allow the economy to not perform especially well in the run up to the 2024 presidential election, because of what that would mean for Biden's chances of reelection. So yes, the kind of fiscal policy that we will be getting, I suspect will be very different from that optimal kind of policy, even if we do get to the effective lower bound in the US.

Paul Diggle 07:24

Lets stick with that. And that thought that the actual policy may diverge from optimal policy, fiscal policy, due to these political economy considerations. The US has a great case much depends on on the midterms. What about the UK then a couple of episodes ago, you hosted a discussion on the UK is market meltdown, even since then, the UK is politics has changed with a new government under Sunak. Of course, how is how a political economy considerations here in the UK going to change what fiscal policy could actually do in the coming recession?

Luke Bartholomew 08:02

Sure. So the new government's immediate priority seems, is to try and restore credibility both with financial markets, but as also households and businesses in terms of having a grip on the public finances. So that means that there's likely to be a fair degree of fiscal consolidation announced in the Fourth Coming Autumn Statement, quite how much, is a little bit up for grabs at the moment. And it depends precisely on sort of the interest rate assumptions that are used by the Office of Budget Responsibility when it comes to its forecasts that kind of growth numbers are assumed, and also what the government's targeting in terms of how much of a cushion it wants to have against its various fiscal targets. But it's seems something in the order of 50 billion pounds of fiscal consolidation over the five year forecast horizon is set to be announced. And I suspect the government will be able to pass that and that sort of deals with its immediate short term issues of restoring credibility, a lot of that work is already being done. I think the interesting issue will come next year when you say we expect to be in a recession, in which case perhaps some of what you might want to do on fiscal policy would shift away from reestablishing credibility and it's about using that credibility that you established to ease fiscal policy. Certainly that will be the demand I expect of some of the government back benchers increasingly, as they turn their attention towards what's likely to be an election in the not too distant future. And the government might find it very difficult in that context to hold together a governing coalition as the different demands on fiscal policy pull in different directions, Some wanting easier policy, the government feeling that it's under quite tight financial market constraints. All of which is to say that it's definitely not going to be questions of optimal policy that will be driving decision making, it will be the hard political calculation of how to keep the governing coalition intact in the run up to an election. And the sense in which financial markets themselves might be providing a constraint on policy options as well.

Paul Diggle 10:21

And even policies like the the energy price guarantee, the more limited form that that's intended to take next year could become harder to sustain in, say, a second, cold winter that may be characterised by some degree of gas shortage. But let's say a few words on Europe, because in the euro zone in the EU, there are also interesting political economy considerations, that are going to drive, what fiscal policy does, and in particular, the growth and stability pact, the European Union's fiscal rules remain temporarily suspended. So European member states have something of a window of opportunity to spend more than ordinarily. And interestingly, it's actually been Germany, which has so far led the charge in doing that, with the 200 billion euro package passed there recently, which included a partial energy price cap. Now Germany, did the spending in a way it was sort of slightly off balance sheet, it meant that it technically didn't breach the German debt, break the constitutional debt break, it wouldn't have breached the fiscal rules, had they still being in place, but really, I find it symbolically important that it was Germany who's gone first and furthest on providing a fiscal offset to these economic headwinds. And that then leads you to think well, what are the other big member states going to do? France is currently drawing up a budget, that forsees something like a 5% deficit in 2023. Now a divided Parliament may mean that there's wrangling about that, but that's the initial proposal. And the new Italian Government, while certainly not leaning, as fiscally profligate, as some may have feared, will no doubt want to spend more than the initial proposals that Draghi had drawn up. So there's this window of opportunity to spend more. On the other hand, the UK experience with financial markets may be somewhat chastening, especially to euro zone economies, that that have kind of a history of being very dependent on spreads. And remember that quantitative tightening in the euro zone is coming, which may also make it more difficult for European economies to kind of open the fiscal floodgates in the recession. Okay, well, that's fiscal policy. Well, the other big arm of macro management is of course, monetary policy. And monetary policy is also in flux already ahead ahead of the recession. So the hiking cycle has been very steep. There are now just the most tentative signs of the pace of central bank tightening, slowing down somewhat as policymakers reflect on the amount of hiking they've already done. The possibility of the of an overshoot of over hiking policy, that inflation dynamics may soon start to see a moderation in headline rates of inflation, and as the coming recession, which isn't in too many official forecasts at the moment, but it's starting to enter some of them, and certainly a big a big consideration, I think in central bank policymaking. So you've seen signals that the pace of hikes is going to step down in Europe in the UK, in the US, it's also been the case in Australia and Canada and Norway, all these central banks, giving hints that they're going to slow down the pace of hikes. I would say, though, that in the US's case in the Fed's case, they'd been very keen to avoid the narrative that that marks a pivot in monetary policy. The Fed has to tighten financial conditions generate a rise in unemployment, that then gets on top of inflationary pressures if they want to meet their mandate. So you see a very careful line being kind of been trodden by Powell where he on the one hand signals a slowing in the pace of rate hikes, but on the other hand, says this is not a policy pivot, the terminal rate is still going to end up well below neutral. Policy is going to be tight. And indeed, a recession is a risk in that scenario. But Luke, that's what monetary policymakers are up to now, but thinking ahead to the next recession, we've been sort of wrestling between ourselves with the question of whether the next recession marks a return to the effective lower bound zero interest rates, or negative in some cases, quantitive easing, or whatever that seems a long way away now but, you know, thinking ahead, that's where it could get to, or whether persistent inflation pressures mean that rates actually remain elevated, they don't get all the way back to zero. Do you want to talk us through the sort of the terms of that debate the considerations there?

Luke Bartholomew 15:34

Sure. Well, you actually summarised it pretty well there. But the way in which we've approached this question is to consult a variety of monetary policy rules. And the way that these things work is that you feed in your inflation, unemployment, perhaps growth forecasts, and then they spit out a quote unquote, appropriate policy rate given that macro environment. And there's all sorts of caveats around these kinds of policy rules and indeed, the reason for consulting a variety of them is that each of them had their slightly different specifications that put different weights on different ways you might approach that kind of trade off, and none of them are perfect. And indeed, none of them take into account especially well, the way in which the Fed's mandate has changed from a standard inflation target to one of an average inflation target, whereby it's meant to consider deviations from inflation in the past. All that being said, these are quite good tools for systematically bringing together variety of different economic inputs and thinking about the different trade offs between them. And I think it's fair to say that the consistent message from variety of those rules is that given our inflation unemployment forecasts for the US over the next couple of years, then it would be appropriate for interest rates to return back down to the effective lower bound. And indeed, that is consistent with the weight of academic evidence that was building up after the financial crisis, we've pointed to the idea that effective lower bound episodes are going to become much more frequent in the future, in part because the equilibrium rate of interest, the normal rate of interest, is that much lower. And so shocks are more likely to tip you back into position where you're stuck at zero. Now, interestingly, what the policy rules that we were looking at show is that, really, it is just about back down to the effective lower bound, that would be appropriate policy. And that's in quite stark contrast to what these rules were saying after the global financial crisis. And after the pandemic. And in both those cases, they were suggesting that the appropriate interest rate, given the inflation unemployment dynamics was significantly negative interest rates. Now of course, the way that the Federal Reserve in the US responded to those kind of signals from these policy rules was not to take interest rates negative, but was to launch unconventional policy, quantitative easing. And so I think it has to be that these policy rules are telling you that that's the kind of interest rate structure that you need. Very, very negative interest rates, that would be the necessary condition to think that this is going to lead not only to a zero, lower bound, effective, lower bound episode, but also more QE. And so that's why on the basis of what these rules are telling us, we think it is just the interest rates get down to zero in the US, but we don't see a repeat of QE this time. Now, of course, that is highly contingent on the inflation profile that was feeding into the rules. And if it turns out that underlying inflation pressure is stickier than we expect then, absolutely interest rates may not fall all the way back down to zero. But I think it is very likely that any sort of recession that is meaningful enough to start to bring inflation back under control would be one in which the Fed starts cutting interest rates. So quiet back down to zero will depend on a variety of variables, but definitely a cutting cycle. And I should say that the other very important thing outside of the inflation dynamics is to bring this conversation full circle is of course, the kind of fiscal path that we see in the US as well.

Paul Diggle 19:24

Yeah, absolutely. So fiscal policy is one of those key contingencies to what monetary policy does. So as a closing thought, then to that we seem to have learnt over the UK has recently experience more about the interdependence of monetary and fiscal policy, and I think maybe our conversation brings that out a little bit as well. Do we think that that interdependence is going to be tested, stretched, stressed during the recession and I have in mind Luke that on the one that policymakers are responding to somewhat conflicting incentives, still high inflation, means monetary policy has to has to become tight, perhaps remain tight for a little while before cutting into the recession. But growth will be will be slowing sharply. And the first inclination of politicians will be to support the economy with fiscal policy. So are we starting to see the beginning of some kind of conflict with monetary and fiscal policy?

Luke Bartholomew 20:28

I look, as you say, a trivial level, there is this interdependence between monetary and fiscal policy in the sense that if policymakers are trying to deliver broadly stable growth in demand, which tends to be the objective of policy, then because both of these tools push on aggregate demand, it sort of makes sense that if you're doing more of that work with fiscal policy, then less of that work needs to be done with monetary policy and vice versa, right. So you can see monetary and fiscal policy moving in different directions all of the time, we tend to call that monetary offset. This is just the idea that the job of monetary policy is to offset the shocks that the economy is hit, including fiscal policy. And it's also the case that you can see monetary and fiscal policy moving in exactly the same direction. That's the case of the zero lower bound episode that I described previously, when monetary policy is constrained, is trying to be as dovish as possible, but still can't get enough stimulus, you'd expect to also see fiscal policy trying to boost demand, as well. So it's perfectly normal both to see monetary and fiscal policy moving in seemingly different directions and also moving seemingly in the same direction. There's nothing especially weird about either of those things in and of themselves. But what's crucial is that that happens within the context of a clear institutional setup, where the objective of price stability is absolutely clear, and that there is within policymakers a division of labour as to who is trying to achieve what and that they're all broadly agreed on the merits of those targets. And the reason that's so important is it is just the case that there are certain kinds of fiscal policy a government could be running that effectively make it impossible for monetary policymakers to achieve price stability, try as hard as they might, if fiscal policy were to keep on easing, and keep on easing and keep on easing, even into an inflationary environment, it could well easily become the case that the price level becomes indeterminate, you're into an extremely high inflation environment and monetary policy simply can't respond and deal with that, in part because of what that would do to the public finances the interest on what the government would be paying. And this is a case that's often referred to as fiscal dominance. So rather than it being monetary policy that offsets everything that moves last that provides discipline in the economy and stabilises prices, monetary policy instead becomes subordinated to the needs of fiscal policy and government financing constraints around that. And that's the deeper level of interdependence between the two of them, they have to be working in an institutional framework where there is there is harmony between monetary and fiscal policy, and it is ultimately a political choice as to whether there is support for that kind of institutional setup. And arguably over the last couple of months or so that was somewhat put to the test in the UK, there were certainly a lot of people talking about the risks of fiscal dominance around the last government's fiscal policies. Now, as well as the fact that we sort of very quickly returned to forms of monetary and fiscal orthodoxy goes to show that there are quite significant guard rails against falling into this paradigm of fiscal dominance, but it is very much still a risk out there, I think.

Paul Diggle 23:59

Yeah, I think even it's not just confined to the UK, there's been the first kind of mutterings from politicians in the Eurozone that perhaps the ECB is over tightening. And Christine Lagarde, the president of the ECB, in turn pushes back in any in press conferences, reminding politicians that fiscal packages should be targeted and temporary, rather than working in the opposite direction to to monetary policy. So I think it's a growing theme, especially as the recession develops to watch whether monetary and fiscal policy are working together, or actually starting to butt heads with each other. But Luke, that was a fascinating discussion on a topic that I think is going to be a really crucial driver of what happens in macro and in markets as the recession we're forecasting gets underway. So thank you, Luke, and thank you to you for listening to Macro Bytes. As ever, please like and subscribe on your podcast platform of choice. Please get in touch with us if you're enjoying the show. If you have any questions for us, macro an email address that's also in the podcast description. But until next time, goodbye and good luck out there


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