Fiscal-monetary entanglement

Quick read:

• Monetary and fiscal policy are typically thought of as independent tools that central banks and governments use to manage the economy. However, elevated levels of government indebtedness in the post-quantitative easing (QE) world mean there is a more challenging trade-off between price stability (i.e., managing inflation) and fiscal sustainability (i.e., managing government debt).
• Compared to other developed market central banks, the Federal Reserve is in a relatively privileged position as it can generate operating losses without needing a government recapitalization. An underappreciated cost of this legal set-up is that monetary policy in the U.S. may remain looser compared with other countries (and likely looser than intended).
• In our tactical multi-asset portfolios, the prospect of greater fiscal dominance over monetary policy leads us to be short long-dated government bonds and short the U.S. dollar.

The economic importance of fiscal policy has grown since the start of pandemic and at this juncture there are no easy choices for central bankers. Elevated levels of government indebtedness and large central bank balance sheets create a direct trade-off between price stability (which requires interest rates above economic growth rates) and fiscal sustainability (which requires economic growth rates above interest rates). The pursuit of price stability through monetary tightening harms central bank profitability, increases government interest expense, and may result in higher overall debt issuance. Alternatively, the prioritization of debt sustainability through a central bank-sponsored overshoot of nominal GDP growth may put price stability at risk. We view this as a situation where the relative independence of monetary and fiscal policies has diminished.

Fiscal dominance

Strategic government spending initiatives – most notably the U.S.’ IRA and CHIPS Act that we discussed in Guns and Butter 2.0 – further complicate the policy tradeoffs. Since these fiscal programs directly target interest rate-sensitive sectors (like construction), they can directly offset monetary tightening. In the US, fiscal stimulus appears to be dominating the monetary tightening that was meant to slow growth in pursuit of price stability. As other countries have already begun to mimic the US industrial growth policies, we should expect fiscal policies to offset monetary tightening in other regions of the world in the coming years as well.

Feeling QuEasy

Central banks purchased large amounts of government bonds in response to the last two recessions and have been slow to unwind fixed coupon bond holdings. Though there have been academic discussions on how large balance sheets would intersect with a normalization of policy rates, we have now reached that reality and central banks find themselves generating large operating losses. The transfer of these capital losses to governments leaves central banks politically exposed. The current deterioration of government finances during a robust economic expansion with above-target inflation likely means that both monetary and fiscal policy will face greater constraints during the next downturn.

Central bank profitability matters

Before this year, central banks were incredibly profitable institutions that bolstered government finances. Profits from QE asset purchases flowed to treasuries and resulted in less issuance than would have otherwise been needed to finance government spending. The chart below shows the remittance of the Fed and Bank of England (BoE) to national treasuries as a fraction of government issuance. The numbers are not small: in 2021, for example, the Fed transferred $109bn to the U.S. Treasury. There have been periods when BoE payments to the UK Treasury amounted to over 40% of net issuance and Fed transfers sometimes amounted to more than 20% of total U.S. issuance. These transfers have lowered the overall supply of government bonds and eased the burden on taxpayers. The chart also illustrates, however, how this dynamic has changed as central banks have normalized policy rates.

Profits from QE asset purchases previously flowed to governments

Exorbitant privilege 2.0: the ability to defer central bank losses

As remittances have ended across developed market central banks, governments must issue more bonds to finance the same amount of spending. For countries that have an indemnity agreement in their central bank charter, the impact is even greater and more immediate. The governments in the UK, New Zealand, and soon Sweden must transfer meaningful sums to recapitalize the negative equity position of their central banks.¹ In the UK, this has contributed to the turmoil in debt markets as BoE losses look set to add 30% to UK Gilt debt issuance this year.

Developed market central banks have gone from generating profits to losses

Relative to other central banks, the Fed charter provides it with greater latitude. That is because it can manage operational losses by using a special balance sheet item known as a ‘Deferred Asset’.² This means that additional U.S. debt issuance from QE losses will likely be backloaded compared to other countries.³ However, the use of an accounting item to delay the recognition of losses does result in some policymaking challenges; it means that the Fed is effectively expanding the monetary base despite trying to slow the economy.⁴ We anticipate that institutional differences across developed market central banks are likely to lead to dispersion in policy and relative government bond supply across countries in the coming years.⁵

Fragility of monetary independence

Monetary and fiscal policy are typically thought of as independent tools that central banks and governments use to manage the economy. However, the current magnitude of losses associated with past central bank policy choices have substantial and direct fiscal implications. This raises the unwelcome prospect of increasing fiscal dominance over monetary policy through indirect channels (like political rhetoric) and more direct channels (like potential changes in legislation around central bank statutes). This potential political by-product of QE was a topic raised by Chris Sims in his 2016 Jackson Hole speech:

The fiscal impact of central bank balance sheet gains and losses are, even with the current levels of expanded balance sheets, modest compared to the fiscal impact that will arise if interest rates rise to normal levels. But once they are large enough to generate public discussion, the balance sheet fluctuations are likely to be seen as more directly attributable to the central bank itself. Drastic drops in seigniorage flows, or even a requirement for substantial capital injections to the central bank from the treasury, could arise. They might mistakenly, or cynically, be portrayed as due to central bank mismanagement. And indeed they would represent the central bank’s taking on risk and thereby making important fiscal decisions. A legislature that realizes belatedly that this has happened may legitimately question whether the central bank has exceeded its mandate.

In our tactical multi-asset portfolios, we seek to deliver diversifying returns that are lowly correlated with stock and bond markets. We do so primarily by seeking out relative value opportunities across different countries. Our insights on the fiscal-monetary trade-off have led us to be short government bonds across developed markets, notably in the UK and Sweden given the large recapitalization costs associated with QE losses. We are also short U.S. dollar vs. currencies of countries like Australia, Canada, and the Eurozone that have been more fiscally prudent.