Normalising monetary policy is political

Bond yields increasingly sensitive to fiscal position

Bill Clinton’s political advisor James Carville said that if reincarnated, he wanted to come back as the bond market because ‘you can intimidate everybody’. It has been some time since bond vigilantes roamed the world, sanctioning government fiscal policy. Remarkably,  two-year Treasury rates are now more than 60 basis points higher than their Greek equivalents. And German 10-year Bund rates are only 150 basis points lower than Italian rates despite a public debt share that is half of Italy’s 130% of GDP.


Much of this is due to aggressive central bank action. Large central banks’ collective balance sheets have risen to more than $15tn, from about $4tn in January 2008, suppressing interest rates.


But as we start 2018, the end of quantitative easing is getting underway in the US and markets are pricing European tightening in. Government bond rates are moving up, and there is talk of the 35-year bond bull market reversing.


Monetary policy has been more prominent than fiscal policy over the past several years. But this relatively technocratic decision-making process is changing into one in which politics is more prominent.


Normalisation will cause government debt servicing costs to increase. Net interest payments by Organisation for Economic Co-operation and Development governments are about half of what they were 20 years ago, even as public debt has increased by around 50%. The average G7 gross public debt load is about 100% of GDP. Monetary accommodation has allowed governments to spend more than they otherwise could have.


And as QE unwinds, bond yields will be increasingly sensitive to fiscal policy. Central banks’ large-scale purchasing of government securities has reduced the intensity of bond market discipline, compressing the difference in yield between low and high public debt countries.


Fiscal instruments will also be needed to manage some of the economic volatility associated with the unwinding of QE, as well as to respond to future economic shocks. Structural pressures are emerging across advanced economies, notably the cost of aging populations and the disruptive effects of new technologies. Fiscal resources, such as social insurance, skills and education initiatives, will be required in response.


In general, small advanced economies – such as Switzerland, the Nordics, New Zealand and Singapore – are relatively well placed to respond. Small economies have exercised fiscal discipline since the global financial crisis; many are running at or above fiscal balance, and have relatively low, stable public debt levels.


However, there are other more indebted governments that are deeply exposed to changing fiscal policy. The UK (roughly 90% of GDP) and the US (roughly 110% of GDP) have high gross public debt levels, as do France and Spain (both about 100% of GDP). Japan is an outlier (gross debt of 240% of GDP, net debt of 120% of GDP). Several of these countries are likely to attract greater bond market scrutiny as well as be constrained in responding to economic dynamics and shocks.


Higher interest rates will have a material impact on households and corporates. The Bank for International Settlements reports rising levels of private sector debt worldwide (household plus corporate debt), at over 140% of GDP in Q2 2017.


The process of normalisation will be as much political as economic and financial. The combination of rising interest rates and existing fiscal constraints provides fertile ground for political conflict over choices between higher taxes and reduced spending (or higher debt), even in the context of improving GDP. Monetary accommodation has had distributive consequences over the past several years. The politics of economic management will become more heated, creating risks for central bank independence in the form of demand for interest rates to remain lower for longer.


Political realities may intrude on an orderly normalisation process. Economic management is unlikely to be a purely technical exercise. There is a global shift underway from rules-based policy systems to more policy discretion and control.


David Skilling is Director of the Landfall Strategy Group, a Singapore-based economic advisory firm.

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