Mike Dolan

LONDON, (Reuters) – Markets might be missing the mixture.

Some argue that investors don’t see the bigger picture of economic policy in the future as financial markets sift through monetary policy tea leaves hourly and continue to be enslaved by major central bank twists and turns.

In the decade prior to the pandemic, one of the major themes was that the western governments had become too dependent on their central bank for economic support. This policy mix kept budget strings tight but real interest rates fell ever lower to maintain demand and deflation.

Within two years of COVID-19 hitting, everything seemed to be on the sand. To keep the economies alive, governments busted the bank. As a result of this lockdown, the deficit and debt rose and the central banks subordinated the borrowing with bond buying and zero interest rates.

But, with growth, inflation and employment returning to their former glory, the reverse of interest rate cuts is underway. This raises questions about how much fiscal firepower we will have in the long term, especially if borrowing rates stay higher and economies slow down again.

The nonpartisan U.S. Congressional Budget Office presented last week what looked at first like a drastic repair to the national accounts back to their pre-pandemic levels.

CBO estimates that this year’s deficit in national budget will fall to 3.9% from 12.4%, and further to 3.7% by 2023, due in part to rising tax revenues, as the U.S. economic recovery continues.

This is a welcome indicator for Treasury bond markets that are waiting for the Federal Reserve’s start to reduce its massive balance sheet of U.S. government debt held during the Pandemic.

However, the CBO 2022 Surprise was not enough to mask a worsening fiscal picture in the next decade due recurring expenditure already approved – as well as the growing interest bill.

The cumulative deficit for the 10 years up to 2031 is expected to increase by $2.4 trillion, compared to the $14.5 trillion forecasted in July.

In 2032, federal interest costs were projected to rise to 3.3% GDP. That would increase debt/GDP ratios by 110%. The average interest rate was 3.1%. 98% of this year’s average rate of 1.9%.

Graphic: IMF chart on global fiscal gaps – https://fingfx.thomsonreuters.com/gfx/mkt/zgpomelampd/One.PNG

Graphic: G7 10-yr real yields – https://fingfx.thomsonreuters.com/gfx/mkt/lbvgndyjbpq/Four.PNG

NO MORE “GREAT COINCIDENCE”

Further massive U.S. fiscal stimulus is now in suspension due to congressional concerns about overheating and spurring close 40-year high inflation rates. Those who have advocated for fiscal restraint seem vindicated, as the Fed tightens credit.

Larry Summers (former Treasury Secretary for Democrats) reiterated his concerns about fiscal policy last Wednesday and indicated that the Federal Reserve was slowly gaining control. He also mentioned in an interview to The Economist that any time U.S. inflation has been above 4%, and the unemployment rate is below 4% over the past 100 years, there have been recessions within two-years.

But, when you consider the impact of this year’s energy shocks from Russia’s invasion in Ukraine and other sanctions on households worldwide, it is possible to demand additional fiscal relief. The additional 15 billion British Pounds (or $18.92 billion) of household support was announced by Britain last week.

For investors who are trying to figure out where real interest rates will settle and how economies will absorb them, it is important that these fiscal or monetary levers be properly configured.

Pascal Blanque (Amundi Institute Chair) believes the period with perfectly complementing monetary and fiscal policy, which he calls the “Great Coincidence”, has ended. This means that it is time to negotiate and coordinate actions among economic policymakers.

It will be hard to miss the spectacle of Tuesday’s highly choreographed meeting between U.S. President Joe Biden, Fed Chair Jerome Powell. The public priority should at most be cutting high living costs.

Blanque believes markets favor further fiscal expansion and full normalization of monetary policy. Blanque believes the former is a “fiscal space killer” and that the biggest risk to the mix is that the economy sinks between the stools, causing recession or even stagflation. This would further reduce risky assets like equities.

He concludes that scenarios in which central banks are willing to allow more fiscal action in both the United States and Europe, are more probable. Portfolios should be infused with assets that provide protection against inflation, whether it is greater or less.

Blanque stated that “the fiscal space” would be used to address critical new public goods, including the energy transition or strategic autonomy. These priority will be met by central banks, which must remain cooperative.

Graphic: CBO 10-year US budget deficit projections – https://fingfx.thomsonreuters.com/gfx/mkt/akvezryeqpr/Two.PNG

Graphic: CBO long-term US public debt projections – https://fingfx.thomsonreuters.com/gfx/mkt/byvrjdnmrve/Three.PNG

The editor-atlarge for markets and finance at Reuters News is the author. All views and opinions expressed in this article are the author’s.

($1 = 0.7930 pounds)

(by Mike Dolan. Twitter (NYSE::): @reutersMikeD. Editing by Tomasz Januaryowski