Over the past thirty years Richard Nixon’s famous comment “we are all Keynesians now” could hardly have rung more hollow. Since the introduction of inflation targeting, economists and the market have looked to monetary policy as the tool for demand management in the economy—fiscal policy barely had a look in. But now the consensus is starting to shift, and one of the most important legacies of the pandemic may well be a more balanced approach to economic policy.
If only it had happened sooner.
For some time, evidence has pointed to monetary policy losing its efficacy as a tool for managing the economy. Indeed, central banks have consistently missed inflation targets for a decade—the evidence is there almost no matter how you frame the problem.
But our analysis points to a vastly weaker empirical link between conventional monetary policy and GDP growth than most assume. This is consistent with the breakdown in the Philips curve—the relationship between inflation and unemployment, on which the crucial link between monetary policy and output in the New Keynesian model relies. Ironically, it might be that central banks might have been too successful in reducing inflation expectations and, in doing so, harmed their ability to affect inflation.
What’s more, our structural modelling suggests that it’s demographic forces that are pushing real equilibrium interest rates deeply negative, even beyond levels that are feasible for actual policy rates to reach, making central bankers’ jobs even harder.
This shouldn’t be a surprise. The current macroeconomic policy framework was designed to confront decades of high inflation generated by often procyclical fiscal policy. But we face a completely different world now after 30 years of structural shifts—many of which the pandemic has exacerbated.
Some will point to soaring government budget deficits and say that we have already embraced fiscal policy as an important demand management tool. But the vast majority of the measures so far have been aimed at mitigating the damage inflicted by the pandemic rather than strengthening the recovery.
Still, as past pandemics show, fiscal policy can be a crucial differentiator in determining the strength of recovery. In fact, the world is already in a liquidity trap. And if policy-makers want to strengthen the recovery they don’t have much of a choice but to embrace more active use of fiscal policy. As the IMF and others have pointed out, 60% of the world economy now has policy rates below 1%. And as we’ve demonstrated, fiscal multipliers can be up to twice as powerful under current conditions.
In a demand-deficient world economy, fiscal policy needs to step up more consistently.
To be clear, monetary policy still has an important role to play—in fact it has two. But both are very much support roles in the current environment.
First, central banks are acting as and must continue to be, a circuit breaker between the economy and the financial sector. The potential for a financial crisis in the wake of such an enormous demand shock is not to be ignored. Among our global client base this remains a persistent and significant worry. But central banks have an impressive arsenal at their disposal to combat such a threat.
Second, central banks’ asset purchases are key to limiting the supply of safe assets and keeping yields and debt costs low. But as issuance limits on purchases approach, central bankers will have to continue to fend off claims of monetary financing.
So a shift of emphasis toward fiscal policy now seems imperative. If it continues, it will define the next phases of the global recovery. Winners and losers will, in part, be decided by how much fiscal space is available to each economy and how it is used. We may also start to see the return of output volatility and current relationships in financial markets may start to break down. What is clear is that the choices made now between becoming a bit more Keynesian and accepting weak growth will have profound consequences.
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