EcoTVWeek - December 2021


In the old days, analysing the impact of monetary policy on the economy was rather simple: it was sufficient to look at the level of interest rates to have an idea about the sensitivity of consumer spending and corporate investments to interest rates and we had a picture of what it meant for the economic outlook. It also meant, for instance, that analysing the orientation of monetary policy started from: where is inflation compared to target ?,  where is unemployment rate and how does it look to the natural rate of unemployment? These were the old days. Then came the Global Financial Crisis and monetary policy has evolved quite significantly since then. The balance sheet has been used in the context of quantitative easing and there’s also the very important use of “forward guidance” whereby central bankers give indications about how their policy would evolve into the future. So monetary policy analysis has become more complex. The increasing role of financial markets, the increasing weight in the economy, but also the use of quantitative easing, which seeks to influence financial markets, means that financial conditions have taken a really important role in influencing the economy, in acting as a transmission channel for monetary policy. It also means however that engaging what the future brings in terms of monetary policy, balance sheet, quantitative easing or interest rates, we also have to look at how financing conditions in financial markets have evolved.  That means looking at the level of sovereign bond yields, looking at the level of corporate bond yields,  what the equity market is doing: whether it is going up down or whether it is volatile, and even what the exchange rate is doing? This has given rise to a concept called financial and monetary conditions and these conditions really influence the financing conditions by definition: consumer spending, corporate investments etc. And that means that they will tell us what we can expect in terms of economic development going forward.

Very recently, with the arrival of the pandemic and in the context of fighting the economic consequences of the pandemic, fiscal policy has taken really a front stage role. It has become very important in trying to soften the blow to the economy but also trying to reinvigorate the economic recovery. From economic perspective, that means that these fluctuations in fiscal policy can have an important role in boosting demand. But also the concern is that when that support slows down, that it would also slow down the economy. A way to analyze it, is what economists call the “cyclically adjusted primary balance“, also known as the structural primary balance. What that means is that we start from the fiscal balance (that is the difference between government expenditures and receipts government revenues), and we then strip out the interest charges. And then we take into account where we are in terms of the business cycle. So that means that we only look at the structural primary balance. What that means is that when that structural primary balance becomes bigger, the deficit increases. There is a positive impulse which is being given to economic activity, to the amount in the economy, so it supports GDP growth. However, when that primary balance narrows, the deficit shrinks: it means that fiscal impulse turns negative. Why is this important? When the fiscal impulse turns negative, that means that there is a headwind that is being created and that monetary policy needs to take that on board in the assessment of what is the appropriate stance, whether the interest rates should remain as they are, whether quantitative easing should continue, or whether time has come to hike interest rates. It brings us in a world where not only should we look at financial and monetary conditions, but we should look at fiscal, financial and monetary conditions.

Where does this leave us today. First of all in a pretty complex world, because monetary conditions, financial conditions and fiscal conditions mutually influence each other. When interest rates are low thanks to central bank policy, there is more leeway for governments to boost the economy. When interest rates are low, financial markets typically thrive. So that means that when anything changes, with respect to monetary policy or with respect to fiscal policy, it can have an impact on the other dimensions of these fiscal financial and monetary conditions. But looking ahead, where are we? We have to make a distinction between the United States and the euro area. Starting with the United States, the Federal Reserve is tapering, is scaling back its base of monthly asset purchases, and that process will be over by the spring of next year. We expect that monetary policy, that interest rates will be hiked as of the summer of next year. So that means that monetary conditions will tighten. That  normally should also cause a tightening of financial conditions. We have to expect that, for instance, corporate bond spreads would widen somewhat; you also have to expect that equity market would become a bit more volatile and then fiscal policy importantly is also expected to bring a negative impulse, to act as a kind of a headwind for the cyclical development in the economy.  I’m saying this based on research that has been conducted by the Hudson Center. So when we put the three things together, it would mean that monetary policy would tighten somewhat, financial conditions should tighten and fiscal conditions as well. So that should act as a headwind for what is after all a “very robust” economy (I’m quoting Jerome Powell). But importantly, we have to keep in mind that, if fiscal conditions tighten and financial conditions tighten, that the necessity for the central bank to hike policy actually declined. So that means that the Federal Reserve could get away with hiking interest rates a bit less because the two other components (fiscal and financial) would also create a bit of a slow down, would also create a bit of a headwind. That is for the US. Let’s now turn to Europe. On the financial conditions, they should benefit from the very accommodative monetary policy of the ECB that will continue,  so monetary accommodation continues and financial conditions should remain accommodative as well on the back of that ECB policy. However, there should be a bit of an external influence coming from the US. That would mean that if you have volatility in equity markets in the US, you have to expect the same in Europe; if you have some corporate bond spread widening in the US,  expect the same to happen in Europe as well. But importantly, based on calculations of the European Commission, the fiscal impulse should remain clearly positive and that should be a supportive factor for growth in Europe. So in the euro area, we have supportive monetary, on the whole, supportive financial conditions and also clearly supportive fiscal conditions. This is an important message at the end of the year, because it gives us a certain comfort in looking at the growth outlook for the euro area in 2022.