Tug of War That Markets Fear Is Central Banks Versus Governments

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In the all-hands-on-deck economics of the pandemic, governments and their central banks shared the same goals. Now they’re starting to pull in different directions.

The tug-of war has already claimed one victim. The UK’s attempt to boost its economy with fiscal stimulus backfired, triggering a bond rout. In the short-term, the Bank of England was forced to step in and support markets, while Liz Truss’s government partially reversed course. In the medium-term, investors are betting it’ll mean higher interest rates for Britons.

Similar tensions may be in store across the world’s financial markets, as economies slow while inflation remains stubbornly high.

When monetary authorities look at soaring prices, they see inflation that must be stamped out -- by driving economies into recession if needs be.

But politicians in charge of budgets see something different, because voters hit by a cost-of-living squeeze expect their governments to help out, which typically means spending more or taxing less.

That’s what many of them are doing -- especially in Europe, where natural-gas shortages caused by the war in Ukraine threaten blackouts and power rationing this winter. Germany alone is planning to borrow as much as 200 billion euros to tackle the energy crisis.

Elsewhere, Japan is adding more fiscal stimulus, and many countries have stepped up food or energy subsidies.

‘Plenty of Reasons’

All of this points to a new policy mix that departs from the recent past.

The decade or so between the collapse of Lehman Brothers Holdings Inc. and the arrival of Covid often saw governments applying brakes to their economies with budget austerity, while central banks -- without much success -- tried to hit the accelerator.

Now it looks like those roles will be reversed, perhaps in part because one legacy of the financial crisis was the view that governments rescued banks but not workers.

The new-look regime is fraught with risks:

  • Public spending may fuel the price pressures that monetary authorities are trying to contain

  • Central bankers, when they raise rates, add to budget costs as governments pay more to borrow

  • There could be bouts of chaos in markets when it’s unclear whether fiscal or monetary officials have the upper hand -- especially if there’s speculation that the central banks are bailing out the governments

“We’re in a world where there are going to be plenty of reasons for governments to spend,” says Dario Perkins, an economist at TS Lombard in London. “They have Covid to deal with, the energy crisis to deal with, if there’s a recession they’ll need to stimulate to deal with that. And the wartime economy, and climate change.”

“But obviously then you have this sort of tug-of-war,” he says. “The more governments ease, the more worried central banks will be about inflation, so the more they’ll be tightening.” And hiking rates “has an immediate effect on government finances.”

Erik Nielsen, chief economics advisor at UniCredit Bank, is particularly worried by the “number of poorly targeted and completely uncoordinated national fiscal packages.”

“If this doesn’t change, we’ll be in trouble,” he said.

‘Painful Budget Cuts’

The danger can be immediate, as the UK found out when Prime Minister Liz Truss’s new government tried to simultaneously cut taxes and subsidize energy bills, at the same time as the Bank of England was scrambling to control prices with higher rates.

Truss’s unfunded proposals triggered a gilt-market rout that had pundits speculating about the return of the so-called “bond vigilantes” –- essentially, investors who police economic policies and sell sovereign debt when they don’t like what they see.

With money no longer cheap, other governments announcing plans to borrow and spend will likely attract that kind of unwelcome scrutiny. Bond yields have surged everywhere with those on 10-year US Treasuries, the world’s benchmark that helps price trillions in global assets, near a 14-year high.

New research by Bloomberg Economics suggests that several major economies are on an “unsustainable debt trajectory, unless they make painful budget cuts.” For the Group of Seven nations as a whole, interest payments on public debt are on track to reach 3.6% of economic output by 2030, more than double the pre-pandemic level, the study finds.

High on the watch-list for would-be vigilantes is Italy, which – like the UK -- has a new government with ambitions for a more expansionary fiscal policy. France and even the US could be next, according to Bloomberg Economics.

The US ran the world’s biggest budget deficit during the pandemic. It’s also pulling back faster than many peers. And as an oil and gas-producing giant, which earns more from exports as prices surge, the US isn’t facing the kind of crunch that’s pushing energy-importing Europe toward new fiscal stimulus.

Even so, there’s potential for the kind of turmoil that engulfed the UK, says Peter Boockvar, chief investment officer at Bleakley Financial Group.

“That bond-market hissy fit could be coming to a US theater near you,” he says. “At the same time that the biggest buyers of Treasuries -- including the Fed -- are retreating, US debts are exploding higher. And the budget deficit is about to do the same, as tax receipts are at major risk if economic growth continues to slow.”

The risk of policies colliding has been high on the agenda in Washington this past week, as the International Monetary Fund hosted a gathering of fiscal and monetary chiefs. The IMF spelled out its house view: central bank-led campaigns to rein in prices should take priority, and finance ministers should help out by tightening their belts.

“Fiscal consolidation sends a powerful signal that policymakers are aligned in their fight against inflation,” the Fund said in its latest Fiscal Monitor report.

Pierre-Olivier Gourinchas, the IMF’s chief economist, likened the UK clash to “two people trying to hold the steering wheel” and pull it in different directions.

But there’s another concern bubbling up too. Essentially, it’s that if central banks and finance ministries all steer in the same direction –- and that direction is tighter policy -- they could end up driving the world economy off a cliff. The World Bank warns that a synchronized rollback of monetary and fiscal support could lead to global recession next year.

In the longer run, central bankers likely won’t have it all their own way, and they may have to settle for inflation above their 2% targets, reckons Paul McCulley, the former Pimco chief economist who’s been watching world bond markets for four decades.

“In Europe and the US, the body politic is not in the mood for a long haul of fiscal austerity,” says McCulley, who now teaches economics at Georgetown University. “There’s no appetite in the democracies for repeating the policy mix that essentially leads to under-target inflation and the rich getting manifestly richer.”

The outlook he sketches probably isn’t great news for investors: With interest rates and inflation structurally higher in the coming decade than they were in the last one, there’ll be headwinds to the valuation of financial assets -- from stocks to bonds -- that have surged in the age of central-bank dominance.

Like other analysts, McCulley sees the UK crisis as a test-case -- and a warning -- for other countries. The way he sees it, both monetary and fiscal policy makers blinked -- first the Bank of England, by stepping in to buy bonds when they plunged, and then the government by dropping some of its proposed tax cuts.

“We’ve effectively had two rounds of this game of chicken,” he says. “I don’t think the game is over, anywhere.”

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