Fiscal-Monetary Entanglement

Quick read

  • Monetary and fiscal policy are typically thought of as independent tools that central banks and governments use to manage the economy. However, elevated levels of government indebtedness in the post-quantitative easing (QE) world mean there is a more challenging trade-off between price stability (i.e., managing inflation) and fiscal sustainability (i.e., managing government debt).
  • Compared to other developed market central banks, the Federal Reserve is in a relatively privileged position as it can generate operating losses without needing a government recapitalization. An underappreciated cost of this legal set-up is that monetary policy in the US may remain looser compared with other countries (and likely looser than intended).
  • In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, the prospect of greater fiscal dominance over monetary policy leads us to be short long-dated government bonds and short the US dollar.

The economic importance of fiscal policy has grown since the start of the pandemic and at this juncture, there are no easy choices for central bankers. Elevated levels of government indebtedness and large central bank balance sheets create a direct trade-off between price stability (which requires interest rates above economic growth rates) and fiscal sustainability (which requires economic growth rates above interest rates). The pursuit of price stability through monetary tightening harms central bank profitability increases government interest expense, and may result in higher overall debt issuance. Alternatively, the prioritization of debt sustainability through a central bank-sponsored overshoot of nominal GDP growth may put price stability at risk. We view this as a situation where the relative independence of monetary and fiscal policies has diminished.

Fiscal dominance

Strategic government spending initiatives – most notably the US IRA and CHIPS Act that we discussed in Guns and Butter 2.0 – further complicate the policy tradeoffs. Since these fiscal programs directly target interest rate-sensitive sectors (like construction), they can directly offset monetary tightening. In the US, fiscal stimulus appears to be dominating the monetary tightening that was meant to slow growth in pursuit of price stability. As other countries have already begun to mimic the US industrial growth policies, we should expect fiscal policies to offset monetary tightening in other regions of the world in the coming years as well.

Feeling QuEasy

Central banks purchased large amounts of government bonds in response to the last two recessions and have been slow to unwind fixed coupon bond holdings. Though there have been academic discussions on how large balance sheets would intersect with normalization of policy rates, we have now reached that reality and central banks find themselves generating large operating losses. The transfer of these capital losses to governments leaves central banks politically exposed. The current deterioration of government finances during a robust economic expansion with above-target inflation likely means that both monetary and fiscal policy will face greater constraints during the next downturn.