Building Confidence in Markets: Fiscal and Monetary Policy

The year 2022 delivered some of the largest blows to global markets in recent decades. As of the time of writing, we have the Russian-Ukrainian war, conflict over Taiwan, China’s zero covid policy and high inflation expectations, just to name a few. All these factors meant a dim global economic outlook ahead. During such uncertainties, both fiscal and monetary policy plays an ever more important role of supporting market confidence and maintaining price stability. The motivation behind this article was the recent Sterling and UK Gilts selloff.

Inflation Factors

Rising inflation and interest rate hikes are among the four major trends impacting today’s stock markets. (CNBC, 2022) Multiple supply shocks led to cost-push inflation in almost every part of the global economy. Most central banks are determined not let high inflation persist and build into a long-term expectation, which can potentially drag us back to the era of stagflation. Figure 1 below plots the change in inflation and policy rates of several major economies from January 2022 to June 2022. We can clearly see that inflation rose across the board, and central bank policy rates have also increased in varying degrees.

Figure 1: Interest Rate Hikes vs Inflation Rate by Country

(Visual Capitalist, 2022)

The strategy of tightening monetary policy is a double-edged sword. It will theoretically tame inflation by reducing demand, but it also reduces economic output. However, with supply shocks worsening month by month, inflation continued to rise despite rate hikes. We are experiencing inflation mainly driven by lack of supply, and hence there is only so much central banks can do without driving the economy into a recession.

Role of the Government

In the face of such uncertainties, governments are forced to choose between two difficult choices. Firstly, it can choose to not intervene and let the economy ride out any possible recession, which is the “quick and dirty” way of bringing down long run inflation expectations. However, this is a largely unpopular approach due to the political consequences that result from it. Sooner or later, a new government will be elected by the masses to provide support to the economy.

Secondly, the government can try to stimulate the economy through a mix of local investments to support jobs and fiscal stimulus packages to offset the effects of inflation. However, the benefits come at a huge cost. For a start any form of fiscal stimulus will need to be financed through borrowing from local or foreign debt markets. This will increase government debt, degrading its fiscal position leading to higher future cost of financing. More importantly, expansionary fiscal policies will sharpy contradict the central banks’ mandate to keep inflation low

Most governments choose a hybrid approach, by letting the economy ride through a recession, while providing support to the most vulnerable. It is important for governments to keep this dedicate balance, as tipping to the extremes will have huge consequences, as we shall see.

Case Study: Fantasy Economics

Figure 2: 30-Year Index Linked Gilt Yields

(The Guardian, 2022)

In September 2022, Liz Truss was elected by the Conservative Party as Prime Minister of the United Kingdom. The markets reacted negatively with the Gilt and Sterling experiencing a major selloff. During her election campaign, she made bold promises to support the economy through a series of tax cuts, helping citizens cope with soaring prices. (The Guardian, 2022) Markets reacted negatively after her appointment, as the packages she promised will significantly impact the government’s fiscal health. From figure 2 above, 30-year inflation-linked Gilt yield climbed steadily after Liz Truss was elected. Soon after, Kwasi Kwarteng announced a mini budget which was larger than what the markets previously anticipated it to be, causing yields to spike above 5%. Amongst the budget was a cap on energy bills per household to help the economy tide through winter. (City A.M., 2022) There are two broad reasons that can potentially explain the markets’ reaction.

1) Fiscal vs Monetary Policy

Markets always favor certainty over uncertainty. From the figure 3 below, the Gilt yield curve remains largely flat at its tail. Markets are pricing in a long-term forward rate that is lower than its medium-term counterpart, signaling confidence in the Bank of England’s ability to bring inflation down, allowing for rates to then fall to a lower level. This confidence is a result of consistency in the central bank’s monetary policy, with the aim to keep inflation low at levels close to 2%. Today, UK’s inflation rate is slightly higher than 10%. The markets hence widely expect the Bank Of England to announce further rate hikes to curb inflation. However, expansionary fiscal policy announced by Liz Truss’ government casted doubt in the central banks’ ability to fight off inflation. With fiscal and monetary policy seemingly diverging, markets are no longer so certain about the long-term trajectory of UK inflation and interest rates.

Figure 3: Gilt Yield Curve

(Financial Times, 2022)

2) Fiscal Position

During the COVID-19 Pandemic, the government announced huge stimulus packages to support the economy, allowing the UK to avoid falling into a recession. The increased government debt casted doubts on the government’s fiscal position, and Liz Truss’ policies amplified the effects of it. Capping of energy bills is expected to cost the government £89bn, according to the base case projections by Cornwall Insight (The Guardian, 2022). Meanwhile, the UK treasury estimates that the tax cuts will potentially wipe out £45bn of revenues annually over the next five years. (CNN, 2022). This budget meant that the government would need to tap on the bond markets for financing, all while biting a chunk off its revenue stream. Hence the markets saw larger risks in the UK’s fiscal position, especially since the government provided no clear indication on how it plans to finance the additional debt burden.

Another key reason for the Gilt selloff is due to collateral requirements of the interest rate derivative positions held by UK pension funds. Such instruments were adopted to generate cash for meeting their liabilities to pensioners. The rise in yields exacerbated the Gilt selloff as pension funds offloaded their Gilt holdings to meet additional margin requirements for their mark-to-market losses. However, this topic is out the of scope of this article and interested readers can refer to the link included in the references.

Confidence is key

The financial markets are forward looking in nature, rewarding stability while punishing uncertainty. The above case study outlined the importance of aligning both fiscal and monetary policy to give markets confidence in the trajectory of economic conditions. Since the stagflation of the 1970s, decades of hard work by central bankers brought inflation expectations down to the levels we are at today. While costs of inflation will be felt throughout the economy, governments should refrain from tipping the balance, which may spark widespread uncertainties and have domino effects in the markets.

We are in a period of cost push inflation, and supply issues are not expected to be resolved soon. Hence demand must come down, even if it means putting the economy through a recession. Large stimulus packages will only stand in the way of monetary policy, making it much harder to combat inflation without rates rising to levels that will bring the economy into a recession. (Barron's, 2022) Instead of providing short term support packages, governments should instead work towards resolving supply side issues, tackling areas such as aging population and education which will improve the long run productivity of the economy. This will provide confidence among investors on the future economic outlook of the country.

References

Barron's. (2022). The Fed Needs a Helping Hand to Fight Inflation. Retrieved from Barron's: https://www.barrons.com/articles/fed-federal-reserve-inflation-prices-51657139587

City A.M. (2022). UK caps household energy bills at £2,500 as Truss promises business help. Retrieved from City A.M.: https://www.cityam.com/uk-caps-household-energy-bills-at-2500-as-truss-promises-business-help/

CNBC. (2022). 4 big factors impacting markets and the economy right now. Retrieved from CNBC: https://www.cnbc.com/2022/09/13/4-big-factors-impacting-markets-and-the-economy-right-now.html

CNN. (2022). The rich are the biggest winners of Britain’s tax-cutting gamble. Retrieved from CNN: https://edition.cnn.com/2022/09/26/economy/uk-tax-cuts-benefit-rich/index.html

EFG International. (2022). UK mini-budget sparks gilt market mayhem. Retrieved from EFG International: https://www.efginternational.com/sg/insights/2022/uk-mini-budget-sparks-gilt-market-mayhem.html

Financial Times. (2022, October 27). Bonds. Retrieved from FInancial TImes: https://markets.ft.com/data/bonds

Financial Times. (2022). UK gilts sell off as Bank of England fails to soothe market. Retrieved from Financial Times: https://www.ft.com/content/c7ed9668-e316-4672-99fb-2bffa841b7e8

Reuters. (2022). UK gilts surge on speculation about mini-budget U-turn. Retrieved from Reuters: https://www.reuters.com/markets/europe/uk-bond-market-pressure-eases-bit-end-boe-buying-nears-2022-10-13/

The Guardian. (2022). Liz Truss’s brief, tumultuous tenure as prime minister – in six stark charts. Retrieved from The Guardian: https://www.theguardian.com/politics/2022/oct/20/liz-truss-seven-weeks-as-prime-minister-in-charts

The Guardian. (2022). UK price cap on household energy bills expected to cost £89bn. Retrieved from The Guardian.

The Guardian. (2022). What policies will Liz Truss pursue as Britain’s new prime minister? Retrieved from The Guardian: https://www.theguardian.com/politics/2022/sep/05/what-policies-will-liz-truss-pursue-as-britain-new-prime-minister

Visual Capitalist. (2022). Interest Rate Hikes vs. Inflation Rate, by Country. Retrieved from Visual Capitalist: https://www.visualcapitalist.com/interest-rate-hikes-vs-inflation-rate-by-country/