Research Briefing | Nov 14, 2022

Global: Is there a role for fiscal intervention after UK debacle?

Fiscal policy has begun to play a more active part in business cycle management, having been held on the sidelines for a time. But while its role in pushing up inflation and the market reaction to the UK “mini budget” may put a damper on fiscal interventions, that is by no means certain. Should governments continue to try to manage demand, then expect greater volatility ahead.

The 2010s have shown that fiscal policy can play a crucial role in economic management. If there is no conventional monetary policy space, plenty of spare capacity, and an excess supply of savings, the risks of economic overheating or crowding out of private-sector investment are minimal. Fiscal support may achieve a better combination of economic growth and inflation.

But when supply shocks dominate and inflation pressures are greater – as appears to be the case currently – more-active fiscal policy makes it harder for central banks to meet their mandate. Shifts in the fiscal stance may result in more volatile inflation, policy rates, and economic growth.

If we return to a world of secular stagnation, then economies will benefit from interventionist fiscal policy, reducing the risk of policy rates becoming stuck again at the lower bound.

But if inflation remains above target and governments concurrently fear a repeat of the 2010s, then a loosening of fiscal policy will result in bigger swings in policy rates, inflation, and the business cycle.

Surging bond yields might temper government fiscal plans, as occurred in the UK where the government reversed its plan. But there’s also a risk of a messier outcome. If markets expect central banks to cap bond yields for financial stability reasons, irrespective of the shock, this could weaken the extent to which markets punish fiscal laxity. Ultimately, that could lead to financial or fiscal crises further down the road.

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