For much of the post-Great Recession era, economic policy in most major economies has been characterised by a mix of tight fiscal policy (“austerity”) and loose monetary policy (very low interest rates and easy availability of central bank money).
The results, after 10 years of this policy mix, are clear. On the fiscal side, government balances have improved markedly: for the OECD as a whole the general government primary balance went from -1.9% of GDP in 2008 to -6.6% in 2009, and then narrowed to near balance (-0.2% of GDP) by 2017.
Although for this year and the next, the pan-OECD deficit is forecast to widen very slightly, this is heavily affected by the position in the US, where President Trump’s tax cuts have caused the fiscal deficit to widen sharply, and elsewhere the improvement in fiscal balances is set to continue.
For the Euro Area, for example, the equivalent numbers are a primary balance of 0.4% of GDP in 2008, moving to a deficit of 3.8% of GDP in 2009 and 2010, then moving back into surplus by 2016 and forecast to exceed +1% of GDP by 2019 (all data from the OECD Economic Outlook 2018, vol I). Other advanced economies follow a roughly similar trend, although the details may differ.
At the same time, loose monetary policy has resulted in strong broad money growth. World broad money growth (excluding China, which implemented a major monetary stimulus in 2008) slumped from 8% in 2007 to -0.9% in 2010, but then recovered to 5.1% in 2017.
What was the resulting outcome for global economic activity of this policy mix? Unequivocally, it was positive: OECD GDP slumped by 3.5% in 2009 but growth has since averaged slightly more than 2% a year (although the numbers are slightly different, world GDP growth shows a similar pattern). Within the OECD, the US economy has grown faster than the European ones, with Italy in particular disappointing among major economies.
In other words, in the combination of tight fiscal policy (usually a drag on economies) and loose monetary policy (usually a stimulus), it appears to have been the loose monetary policy that dominated and drove the resulting global recovery. Indeed, economists now debate whether the improvements in fiscal balances around the world in the last 10 years is due more to austerity (higher taxes and lower spending) or due more to recovering economies (higher tax receipts from booming economies).
The answer is not clear-cut, but, awkwardly for those politicians in countries like Germany and the UK who have talked a lot about the need to restore fiscal orthodoxy and curb public spending, the strong suggestion is that exchequer balances have improved more due to recovering economies than tax increases and spending restraint.
At the same time, substantial spare capacity almost everywhere has meant that, in spite of above-trend growth, inflation has remained quiescent. It has given the world its current combination of positive growth, improving government balances, lower unemployment and still low inflation. What’s not to like? And indeed the last few years, especially 2017, have by and large been good for financial markets.
However, this policy mix now looks set to change. There is a global reaction against austerity, and while the strength of this reaction varies from country to country, it is broadly based. The United States has enacted a major fiscal stimulus (though ironically, given President Trump’s fixation on the trade balance, stronger growth in the United States is likely to widen the US trade deficit, regardless of his tariffs). The British government is loosening its purse strings. The Italian government is engaged in a major confrontation with the European Commission, which, however it ends, is likely to mean looser fiscal policies than originally intended. The Chinese government, concerned about the impact of the US-initiated trade war on its economy, is eyeing fiscal easing. And so on.
Meanwhile, after years of ultra-loose monetary policies, central banks are moving towards normalising (although not yet really tightening) their stance. This is taking two forms: higher interest rates, a process already begun in the United States, Canada and the United Kingdom, and likely on current trends to begin in the Euro Area next year; and ending and eventually reversing quantitative easing in countries where this took place, again, begun in the USA (reversal) and the UK and Sweden (ending) and coming to the Euro Area in early 2019.
This shift in policy is getting added impetus from the fact that headline inflation in most major economies (and core inflation in some of them) is reaching its target. Even in Japan, inflation, 1.6% in the year to October, is at a 4 ½-year high.
On the face of it, therefore, the switch in policy mix seems justified. However, three issues give cause for concern:
First, broad money growth has recently slowed substantially in the largest economies. US broad money growth has halved, from more than 6% in mid-2017 to below 3% in late 2018. Euro Area broad money growth has slowed less, but from above 5% to around 4.5%; in the UK, the slowdown is from 6-7% to barely above 5%; and in Japan from around 3.5% to around 2.5% over the same period. The most pronounced slowdown is in China, where M2 growth has been below 9% for eight of the last twelve months. This is the weakest performance since reliable Chinese monetary data began in 1986.
Second, other leading economic indicators, such as sentiment, housing market data and car sales are also showing signs of weakness, confirming the monetary message.
And third, and most worryingly, all experience – including, as noted above, the post-Great Recession era – shows that if monetary and fiscal policy are working in opposite directions, it is monetary policy that matters. Fiscal policy can reinforce monetary policy, but, on its own, tends to have much less impact.
Hence, the economic and monetary data is pointing towards a slowdown in global activity in 2019. And on top of that the dominant policy (monetary policy) is generally moving in a pro-cyclical direction (ie, tightening as economies slow), which is likely to exacerbate that slowdown. True, the Federal Reserve is likely to pause its interest rate increases in 2019. But elsewhere, monetary policy is mostly still driven by a desire to normalise policy.
This is unlikely to be good for asset prices, and is one reason for the current softness in equity markets. An end to austerity does not yet mean any major fiscal stimulus; and even if it did, that would, as noted above, most likely have limited impact. By contrast, any withdrawal of liquidity – and that is what no more QE, the beginning of QT or simply slower broad money growth all boil down to – means that the monetary underpinning for asset prices over the past eight years will diminish and disappear.
It is difficult to know what markets should wish for. Slower output growth now will mean continued subdued inflation and less need for higher interest rates – but it will also mean weaker asset prices. But while a much stronger fiscal stimulus – for example if the rest of the world was to follow the US lead – could possibly boost activity and keep markets more buoyant in the short run, it would also spur fears of inflation, causing central banks to step up their normalisation/tightening. If they do not, then by this time next year they may find themselves having to play catch-up as inflationary pressures take hold.
And if there is one thing asset markets really do not enjoy, it is the combination of rising inflation and rising interest rates from central banks deemed to be behind the curve.
Either way, the outlook for asset owners is becoming less appealing.