The long path to fiscal credibility

Florian Ielpo, PhD - Head of Macro, Multi Asset
Florian Ielpo, PhD
Head of Macro, Multi Asset

key takeaways.

  • After years of fiscal spending, 2025 could mark a global shift towards fiscal consolidation
  • Countries have various fiscal positions, and significant efforts may be required from the US, UK and France to achieve consolidation
  • Without these efforts, markets could penalise lagging countries by increasing their long-term real rates, potentially hindering growth and triggering snowball effects.

We start with a brief review of the macroeconomic landscape. In the last quarter, our macro signals indicated minimal signs of growth deterioration, and this sufficiently low probability of recession ensured the inaugural 50 basis-point cut from the Fed was viewed as positive news for global markets. Currently, growth forces continue to gain momentum, as evidenced by our indicators, which suggest a shift to a more autonomous monitoring approach in this area. The critical question for 2025 concerns the direction of fiscal policy.

To date, the policy mix has included stimulative fiscal measures coupled with a tight monetary policy. The fourth quarter was characterised by the pricing in of rate cuts globally, lowering the counter-cyclical impact of monetary policy. The first quarter of 2025 may bring another significant macroeconomic theme to the forefront: tighter than anticipated fiscal policy, which at present appears more as a risk than a likely scenario. Nevertheless, this issue merits further investigation.

Read also: A new rate environment: what do higher bond yields mean?

Should we anticipate a significant tightening of fiscal policy in 2025? If so, in which regions? Where is it most needed? And finally, what impact might this have on debt markets, where fiscal policy arguably plays the most crucial role?

So far, so good

The fourth quarter was marked by a recovery in growth and inflation pressures to achieve what can be described as a ‘nominal recovery’. Market attention has particularly focused on the US, where the growth acceleration has been modest. However, our indicators suggest that the most vigorous recoveries are currently unfolding in Europe and China. As a side note, Sweden – representative of a small open economy – is now exhibiting strong positive signals on our macro dashboards, likely indicating that the global business cycle is on an upward trajectory and gaining momentum – good news for corporate profits.

Figure 1 delineates the regional breakdown of our growth and inflation nowcasters. It is evident that the acceleration in the growth signal is becoming more pronounced, while the inflation indicator reveals a swift ascent. Surprisingly, the Asia Pacific region, propelled by improvements in Chinese data due to fiscal policy adjustments, leads in terms of growth. In terms of inflation, North America is experiencing the most significant upturn, while Europe lags.

This environment is generally favourable for risk-taking, as it is likely to lead to positive earnings surprises and a reduction in global corporate default risk. While there may be concerns about the rapid rise in the inflation indicator, it is difficult to foresee an inflationary episode similar to that of 2021. The current inflation resurgence is persistent and driven by demand, but on a much smaller scale than the episodes in 2021-2022. The underlying reason? Fiscal policy. For instance, it is highly improbable that the US will see primary deficits reaching the levels of 13% in 2020 or 8% in 2021 again, given the current state of public finances in developed market (DM) economies. The critical aspect to monitor in the upcoming quarters is the behaviour of fiscal policy.

FIG 1. Growth and inflation nowcasting signals across economic zones1

Reading note: LOIM’s nowcasting indicator gathers 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).

Fiscal consolidation is already underway

There often tends to be an excessive focus on the US economy, at the expense of broader global perspectives. Monetary policy exerted significant pressure on economic activities worldwide throughout 2023 and 2024, necessitating a stimulating fiscal policy to cushion its impact on the economy. Figure 2, featuring dots that transition from light to darker grey over the years, illustrates the recent and anticipated evolution of these primary deficits. According to the IMF’s World Economic Outlook, the global average primary deficit-to-GDP ratio stood at 2.9% in 2024, consistent with 2023 levels, while a decrease to 2.4% is expected in 2025. This reduction represents a less stimulative fiscal policy of 0.5% of GDP globally (for DM economies), which is not insignificant. In specific countries, government plans could lead to even more substantial deficit reductions: 1.4% in Italy, 3.4% in Japan and 0.9% in the UK (IMF projections).

This trend, commonly referred to as fiscal consolidation, warrants caution due to its potential impact on global GDP and corporate profits. Moreover, IMF projections highlight the consistency of this trend, with almost all countries showing expected improvements in their primary deficits. This could reflect expectations of improved economic growth. However, while the IMF forecasts a nominal growth increase from 3.7% to 3.75% for DM countries, this slight improvement of 5 basis points is unlikely to fully account for the expected betterment in primary deficits. Instead, it suggests an element of ‘active’ fiscal consolidation, which is a critical factor to consider in 2025.

FIG 2. Primary deficit dynamics per country from 2023 to 2025 and long-run projections from the IMF’s World Economic Outlook1

Who’s on the right path?

In the field of economics, the ‘debt dynamics equation’ is a fundamental conceptual tool used to dissect the evolution of debt-to-GDP ratios based on several key variables. This equation is expressed as follows:

Change in debt-to-GDP ratio = primary deficit to GDP ratio + (rates - nominal growth) x current debt-to-GDP ratio

This equation plays a crucial role in assessing how a country manages fiscal consolidation or expansion. It hinges on two factors: a controllable element and a combination of structural factors and chance. The controllable element is the primary deficit, which is the difference between fiscal revenues and expenditures, excluding borrowing costs. The structural element is the differential between nominal interest rates and economic growth rates. For instance, if an economy expands at 5%, but interest rates are at 1% with a debt-to-GDP ratio of 100%, the debt level can stabilise even with a primary deficit of -4% of GDP: the debt ratio can decline if interest rates remain sufficiently below the growth rate, as long as primary deficits are not too strong.

Read also: Higher US tariffs: winners and losers

This equation is invaluable for analysing which countries are on a sustainable fiscal path, where the debt-to-GDP ratio does not consistently rise. Figure 3 provides such analyses over the next decade, illustrating that not all countries are positioned equally when projecting into the future. Essentially, there are three groups of countries:

1

Countries where debt is currently not a problem and is unlikely to become one: Germany and Switzerland exemplify this group. They have low debt levels, well-managed deficits and interest rates that are lower than nominal growth rates, creating an ideal fiscal situation. Fiscal tightening is not anticipated here.

2

Countries where debt is problematic but improving: this group includes Japan and, to a lesser extent, Italy, which is expected to experience only limited fiscal deterioration over the next decade.

3

A broad group of countries with poorer control over their fiscal circumstances: this includes the US, UK and France, where primary deficits are not projected to improve significantly. Additionally, in countries like the UK and Italy, and nearly so in the US, nominal growth rates are not sufficient to significantly reduce debt-to-GDP ratios.

Countries in the last group will need to exert effort to steer their debt levels onto a sustainable trajectory for two reasons. First, the phenomenon of ‘Japanification’, where high debt levels become a drag on economic activity, is not exclusive to Japan and can afflict other economies. Second, if market perceptions of an economy's creditworthiness deteriorate due to unsustainable debt dynamics, interest rates could rise, further exacerbating the debt situation. The key question remains: how is the market currently pricing this risk?

FIG 3. Debt-to-GDP trajectories simulated from the ‘debt dynamics equation’ based on long-run growth and inflation projections and current rate levels1

Pricing debt risk

It is hard to measure a fiscal premium in rates. The one thing we know is that it is implicit in real yields, that is the part of yields that has been discounted for inflation. Figure 4 compares the projected change in debt-to-GDP ratio from Figure 3 in the next 10 years with current real yields. This chart should help the reader understand how this consensus IMF scenario gets priced into markets. The chart shows an estimate of that relationship: every 10% increase in debt ratio in 10 years is about a 32 bps increase in real yields.

This is material: say the US decides not to consolidate its fiscal position and let that projected ratio deteriorate by another 10% - real yields could near 2.5% on their 10-year tenor, a situation that could prove more difficult to manage for the US economy. The chart also shows how some countries have created enough credibility for their debt trajectory to undershoot the average reaction of the others (Switzerland and the Netherlands), while others are overshooting that relationship (the UK, Greece or, more marginally, Italy and Portugal). The message here is simple: fiscal consolidation leads to fiscal credibility, but it is a long journey. 

FIG 4. Debt-to-GDP expected deterioration in 10 years vs real rates1

This insight is an excerpt from our latest quarterly edition of Simply put. To read the full report, please use the download button provided.

 

LOIM Asset Simplyput-Q12025.pdf

 

 

Simply put quarterly edition: Will fiscal policy catch investors off guard?

 

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1 Source: Bloomberg, LOIM, as at 18 December 2024. For illustrative purposes only.

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