The Risks of Pro-Cyclical Policy

abacus

The idea that monetary and fiscal policy can and ought to be used to ameliorate the business cycle, to avoid the kind of boom/busts that lead to social instability and radical ideologies is a rather modern notion, and it remains somewhat controversial.   Many now see it as hubris that policymakers can tame the business cycle.   However, for those who subscribe, the general understanding is that policy ought to be counter-cyclical. 

In a cyclical expansion, tax revenues are higher and social support funding, such as unemployment compensation, are lower.  Budget deficits ought to fall, and even Keynes’ did not advocate a permanent deficit.  Some policymakers in the UK even formally thought about the budget balance over the course of entire business cycle.

In addition to the automatic stabilizers, governments may want to fill in the breech in private sector demand with new public spending–consumption and investment.  And indeed, many countries provided additional fiscal support to bolster aggregate demand in the 2008-2009 period.

Monetary policy is supposed to work the same way.  The longest-serving Chair of the Federal Reserve was William McChesney Martin (1951-1970).  He had to resist the pressure from President Johnson who wanted easier monetary policy.  Martin explained how the central bank needed to “lean against the wind” of inflation and that the Fed’s jobs was to “take away the punch bowl just as the party gets going.”   This too has become part of the inherited wisdom.

The problem, it seems, is that policy may be becoming pro-cyclical.  Many are critical of the fiscal stimulus the US is providing through tax cuts and spending increases while the economy continues to grow above trend.  It produces a large deficit and increases the US debt burden, but even those who accept the need for public investment have serious reservations about the magnitude of the fiscal stimulus now.

Given that the US economic recovery began in 2009, it is not surprising that it is increasing displaying late-cycle characteristics, even if the fiscal stimulus gooses the economy a bit this year.  We have loosely anticipated a growth recession if not an outright contraction in late 2019 or 2020.  The cyclical expansion in the budget deficit will begin from a higher level, as will US debt levels.  The price to pay for the pro-cyclical fiscal stimulus now will be higher debt and likely higher interest rates later.

Europe may find itself in a similar position.  Under reform fatigue, several countries appear poised to increase fiscal support, including Germany (if the SPD approve the new Grand Coalition) and Italy (depending on next month’s election outcome).

The recent string of surveys from Europe suggest that the economic momentum may have peaked at the end of last year.   To be sure, this does not mean the end of the business cycle is around the corner, but by the time the ECB raises rates, likely around the middle of 2019, the risk is that the regional economy would have already begun slowing.  If the goal is to lengthen the duration and lower the amplitude of the business cycle, a pro-cyclical monetary policy would threaten the opposite.

The Bank of Canada hiked rates in July and September last year.  In the H1 2017, Canada’s monthly GDP rose 0.4%.  In the next five months, the average monthly GDP edged 0.1% higher.  The estimate for December will be released next week along with Q4 GDP.   Growth in Q3 slowed to 1.7% annualized pace.  It was the slowest since the unexpected contraction in Q2 16.  The Bank of Canada became the first major central bank to hike rates this year.   After that hike was delivered the market quickly discounted more than a 50% chance of a follow-up hike in April.

The risk is that the Bank of Canada continues to remove accommodation as the economy softens. Although Canadian retail sales were a major disappointment today falling 0.8% and dropping 1.8% when auto sales are excluded, it is consistent with 2017 being a year of two halves for Canada-strong in the first half, weaker in the second.

Japan has been unable to exit its extraordinary policies despite among the longest modern expansion.  Monetary policy appears still be open spigot even though the pace of the BOJ’s balance sheet expansion has slowed as it augments its QQE with yield curve management.  Fiscal policy has been expansionary.  The deficit stood at 5.0% of GDP last year, down from 5.7% in 2016.  With the BOJ’s massive holdings of government bonds, a financial crisis over Japan’s debt seems remote.  That said, the path seems unsustainable and long-term investors recognize that.

 Next year, Japan is slated to raise the retail sales tax (from 8% to 10%).  The risk is that that Japanese economy is slowing when the tax which has been postpone a couple of times.  Japan’s Prime Minister is loath of postpone it again, after running last year’s campaign against an opposition party that wanted to cancel the sales tax increase.  Abe has conceded that part of the funds raised will be used for tax cuts rather than debt reduction, which had been the original intent.

Although the world enjoys a synchronized expansion, the Great Financial Crisis may not be truly over until the downside of this business cycle is managed. Pro-cyclical monetary and fiscal policies exacerbate the challenge that lies ahead for investors and policymakers.