An exceptional intervention?

The current market crisis in the UK has the investment world on edge. The announcement of an "unfunded" tax package by new Prime Minister Liz Truss’s government led to a sharp rise in bond yields, putting many pension funds in a dangerous situation with their LDI¹ portfolios. The subsequent emergency intervention by the Bank of England (BOE) on 28 September halted the rise in rates and eased the nervousness of the bond markets, at least temporarily.

So is this an exceptional situation? And what influence will these tax packages have on the economy? Many European countries have already taken similar steps so this is an important consideration for the end of 2022. Economic theory is familiar with such issues – the famous Ricardo-Barro effect and the interventions in 2020 highlight the consequences of tax packages financed by central banks. Here we consider each of these elements, given they are so central to the crisis happening today.

 

Ricardian equivalence

Taxation theory is an important part of economics. One of its best-known elements is known as "Ricardian equivalence" or "Ricardo-Barro" equivalence, named after the economists who originated it. The point is very simple: in the long run, tax expenditure is necessarily ineffective because the money that the state spends today must lead to taxes being raised tomorrow to finance it. If this is not the case (i.e. if the repayment of the extra debt is continuously postponed), then the quality of the state's credit rating deteriorates and the rates at which it borrows – its "fiscal" premium – rise. The increase in the cost of the state's debt thus cancels out part or all of the stimulus (although such a stimulus can provide cushioning properties during recessions, such as in 2008 and 2020).

Our point is this: equivalence only works if the central bank does not disrupt the natural functioning of markets and economic behaviour; in other words if it maintains its independence.

 

Quantitative easing to the rescue

Since 2020, the situation has become more complex. Unable to accurately measure the extent of economic damage caused by pandemic containment measures, governments deployed unprecedented fiscal packages, notably in the US and UK. In March 2020, the Trump administration announced a USD 2 trillion programme to counter the effect of lockdowns, representing 10% of US GDP, with no real plan to fund it. Figure 1 shows its effect on US 5-year rates. Nominal rates can be broken down into an inflation expectation, a fiscal premium and a residual: real rates. The announcement of the plan led to a double short-term effect:

• a rise in the fiscal premium of 10 basis points, reflecting the deterioration of the country's finances
• a rise in real rates of 1.2%. This rise in real rates reflected a "crowding out effect": the government drains capital from markets that companies will not be able to use, driving them out of markets and raising the price of money

These two effects would have greatly reduced the impact of the Trump administration's massive tax plan, with the sudden rise in rates weighing on the economy both at that time (crowding out) and into the future (the need to raise taxes). It was the Federal Reserve's (Fed) intervention that solved the problem. By buying the bonds issued by the Treasury, the Fed financed and backed a fiscal deficit over 2020 and 2021 that reached close to 25% of US GDP in aggregate. We know the rest of the story: the demand shock created by this disproportionate fiscal spending generated a demand inflation shock that central banks are now struggling to contain.

 

Figure 1: Comparison of inflation, tax and real rate premiums in the US in 2020 (5-year rate)

Source: Bloomberg, LOIM. For illustrative purposes only.

 

2020 bis repetita

The situation in the UK today is very similar to that in the US in 2020. Figure 2 shows visually similar symptoms: the fiscal premium is rising, while real rates have also risen. Once again, the central bank has had to intervene to stabilise interest rates. But the situation today is very different. There is no recession (yet) from which to protect consumers and companies, and inflation is raging. While the BOE's decision is explained by the need to fulfil its mandate as guardian of financial market stability, it will have long-term repercussions, in our view.

With inflation rising and affecting more and more sectors, the deployment of fiscal packages forces the central bank to face up to a stern dilemma: continue to fight inflation today or postpone it until tomorrow. Amid the energy crisis, the demand for governments to protect citizens from the effects of the crisis is immense. Yet, every step in this direction will push our central bankers into a corner. If the US Federal Reserve has chosen to target only inflation today, it is because it knows the economic cost of procrastination. Former Fed chairman Paul Volcker's rate hikes had to be excessive and repeated, pushing the (global) economy into a double-dip recession to purge inflationary pressures. The example the UK is showing us today is symptomatic of a scenario that could be repeated in Europe this winter as the energy crisis hits harder.

 

Figure 2: Comparison of inflation, fiscal and real rate premia in the UK in 2022 (5-year rates)

Source: Bloomberg, LOIM. For illustrative purposes only.

 

Simply put, the fiscal package the UK has proposed to deploy today prevents its central bank from fully tackling the issue of inflation. This is a scenario that could be replicated in Europe in the coming few months and could prove to be very economically costly.

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:

• Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data shows that this deterioration has room to go
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
• Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected

 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).