It’s Mostly Fiscal

Last weekend, the Annual Meetings of the International Monetary Fund (IMF) came to a close. This year, they brought together in Washington the central bank governors and finance ministers of 190 member states plus several thousand observers – and for the very first time, they were held as an entirely virtual event. Christian Kopf, Head of Fixed-Income Fund Management at Union Investment, reports from the meetings and looks at the implications for the capital markets.
Christian Kopf


An article by Christian Kopf

Head of Fixed-Income Fund Management and 
member of the Union Investment Committee (UIC)

When the International Monetary Fund was created in 1944 with the aid of John Maynard Keynes, its main purpose was to manage imbalances in the trade flows between its member states. In the wake of the advancing liberalisation of the international flow of capital and the subsequent collapse of the fixed exchange rate system, the role of the IMF also underwent a transformation some fifty years ago. Since then, much of its attention has been dedicated to supporting over-indebted countries in their efforts to put their finances in order – through emergency loans tied to certain fiscal policy conditions. Hence why, in the English-speaking world, it has long been jokingly said that the acronym ‘IMF’ is really short for ‘It’s Mostly Fiscal’. Now, fiscal policy is also taking centre stage in the coronavirus crisis management of the industrialised nations, albeit not in the way that the IMF had long envisaged.

The role of monetary policy

For the capital markets, monetary policy initially gained ever greater importance due to the transition to flexible exchange rates. The first time I attended the Annual Meetings of the IMF was in Prague in September 2000. In the 20 years since then, the discussions with central bank representatives were often some of the most hotly debated. Every word uttered by Ben Bernanke, Mario Draghi or Haruhiko Kuroda was carefully weighed and analysed. Could interest-rate hikes and a stock market slump be looming in the US? Will the yen continue to depreciate due to the Japanese central bank’s bond purchases? Monetary policy decisions often had a substantial impact on the economy, the capital markets and currencies, and central bankers gained an almost rock star-like status. This was especially true in the years after the global financial crisis of 2008, when many governments were staring at their towering public debt like a rabbit caught in the headlights, while the central banks were setting the agenda.

This dynamic has changed in the coronavirus pandemic. To me, the most important takeaway from this year’s IMF Annual Meetings is that for the foreseeable future, monetary policy will no longer be calling the tune in the capital markets.

The prevailing view in the web conferences held over the past week was that the real interest rate at which the willingness to save and the propensity to invest are in equilibrium in the developed economies continues to fall due to a variety of structural factors and is being further dramatically depressed by the coronavirus crisis. The central banks seem to have come to the same conclusion and have lowered money market rates to their effective floor in order to prevent mass unemployment and deflation. In nearly all developed economies, money market interest rates already stood at or below zero in 2019, and in its efforts to manage the fallout from the coronavirus pandemic, the US Federal Reserve also brought its base rate down from 1.9 per cent to virtually zero over the past twelve months. The decision of US monetary policy makers to pursue a path of higher interest rates since December 2015 is now being regarded as a mistake by many – including Lael Brainard, an influential member of the Fed’s Board of Governors, who is already being tipped as a candidate for the post of Treasury Secretary in a potential Biden administration. In March 2020, this US monetary policy solo trip was ended abruptly by the pandemic.

Key interest rates of major central banks close to zero percent

Key interest rates of major central banks close to zero percent
Sources: Bloomberg, Refinitiv, Union Investment; as at 19 October 2020.

In addition to interest-rate cuts, the central banks have also been purchasing assets at a massive scale since the beginning of the pandemic, in order to prevent the sudden spike in volatility in the financial markets from becoming a threat to macroeconomic stability. In this regard, they have taken a very aggressive approach. After the global financial crisis of 2008, it took five years for the Federal Reserve to increase its balance sheet by US$ 3 trillion. This time, it added the same volume in just three months in response to the coronavirus crisis.

Monetary policy: change in central bank balance sheets

Monetary policy: change in central bank balance sheets
Sources: Macrobond, Union Investment, as at 23 September 2020.

Greater coordination of fiscal and monetary policy?

With this course of action, the central banks managed to avert the worst – but the 2 per cent inflation target remains a very distant prospect and the limitations of monetary policy are becoming increasingly evident. In last week’s discussions, Japanese central bankers recalled how, for decades, they were being told by their Western colleagues that their country’s low level of inflation was entirely attributable to monetary policy errors. These allegations have died down in light of persistently low inflation in the US and Europe, which has remained unaffected by very aggressive interest-rate cuts and is now falling even further in the wake of the coronavirus pandemic. In fact, it has become the accepted wisdom that monetary policy needs to act in tandem with fiscal policy in order to succeed. The IMF is promoting this change of approach. And, as IMF Chief Economist Gita Gopinath clearly emphasizes, the organisation now advises its member states to implement the maximum viable level of fiscal stimulus measures rather than preaching fiscal consolidation like it used to.

We are therefore leaving behind the world in which the central banks were “the only game in town”, as renowned investment strategist Mohammed El-Erian puts it in one of his book titles. We are also leaving behind the world in which the IMF was a warning voice against burgeoning sovereign debt and are instead entering a new environment in which the Fund is actively calling for large-scale public borrowing to overcome the current crisis and encouraging governments to take their time before starting to consolidate their finances.

The proposed paradigm shift that is currently attracting a lot of attention in this debate is Modern Monetary Theory (MMT). Stephanie Kelton, a prominent exponent of this approach, will be speaking at Union Investment’s risk management conference in a few days’ time. MMT advocates for state spending to be funded directly by the central bank. It is grounded in the principle that nation states can issue an almost unlimited amount of debt provided it is in their own currency, and on this basis calls for an end to the separation of monetary and fiscal policy. Although representatives of central banks rejected this demand at the IMF Annual Meetings, they conceded that the current exceptional times call for exceptional measures. The Fed’s Jerome Powell and the ECB’s Christine Lagarde do not view these appeals for higher state spending as being incompatible with the independent status of the central banks. New York-based economist Nouriel Roubini got to the heart of the matter in one of the debates, saying they might call it “greater coordination of monetary and fiscal policy” for form’s sake, but in reality that would simply be a euphemism for what they are actually doing, which is putting MMT into practice. He posited that it makes little difference whether the purchases of government bonds are now made in the secondary market, as the major central banks prefer it, or in the primary market, and strongly doubts whether this monetization of budget deficits really will be a purely short-lived phenomenon. Three years ago, the Fed attempted to bring the size of its balance sheet back down again by selling government bonds and this triggered turmoil in the global financial markets. The Fed eventually had to cave in and it put a stop to these efforts at the end of 2018, according to the prevailing logic.

In economic policy practice, however, fiscal measures are playing a much more active role. According to the IMF’s estimates, fiscal deficits will rise from an average of 3.9 per cent to 12.7 per cent of GDP, which will limit the contraction in global economic output to around 4.4 per cent in 2020. This increase in budget deficits by 8.8 percentage points, a magnitude that only recently would have been completely unthinkable, is likely to be skewed much more heavily towards the developed economies (up 11.1 percentage points to 14.4 per cent of GDP) than in the emerging markets and lower-income countries (up 5.6 percentage points to 10.7 per cent of GDP).

Effect of fiscal policy: depression was prevented

This aggressive fiscal policy, in support of the equally aggressive monetary policy that has been in place for a number of years now, has proved highly effective in the short term. It averted a deep global depression and saved many companies with actually quite healthy business models from insolvency. And in the coming years too, given the ultra-low level of interest rates, there is little to suggest that we won’t see further increases in debt-fuelled state spending. The IMF estimates that in the current environment, which features a high level of uncertainty for businesses, an increase in public spending by 1 per cent of GDP has the potential to generate around 2.7 per cent of growth. This is because the public spending would trigger significant capital expenditure in the private sector that then creates new jobs. Green investment schemes would be a prime candidate for such spending.

In the medium term, however, the question arises as to what would happen if inflation were to increase again. Globalisation of the trade in goods has been stalling for a number of years now. This is partly due to the trade disputes instigated by the Trump administration, though the rivalry between China and the West is likely to persist even if there is a change of government in the US. This rivalry has also led to a fragmentation of technological development. Android phones, for example, are no longer sold in China. Both these trends have been amplified by the pandemic and could be reflected in higher consumer prices in the medium term. Inflationary forces might also be driven by demographic change, which has the potential to restore workers’ bargaining power after decades of downward pressure on real wages. This is the core premise of a new book by economists Charles Goodhart and Manoj Pradhan (The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival), which many speakers made reference to during the IMF Annual Meetings. On the other hand, as the authors freely admit, the coronavirus crisis could have a dampening effect on prices by accelerating the trends towards digitalisation and automation. The inflation debate therefore remains as open as ever.

However, if inflation were to rise in the medium term, the central banks would find themselves in a tricky situation. It would be riskier to hike interest rates, for example, as the much higher levels of indebtedness of governments and businesses will only remain viable if rates stay very low. In any case, we are now clearly operating in a world in which fiscal policy will influence and often dominate monetary policy for a long time to come – “It’s Mostly Fiscal,” remember.


Here’s my summary of the discussions: Monetary policy will focus on stabilising the financial markets through securities purchases, but hardly any further cutting of interest rates is expected. Developed economies will make maximum use of the freedom afforded to them by monetary policy and lower their exceptionally high budget deficits only very slowly. Economic policymakers are concerned about growth, not indebtedness. The global economic situation may be fragile still, but it should recover next year, thanks in part to the huge boost from fiscal policy. Inflation is expected to gradually creep up over a time horizon of several years during the recovery phase. However, interest rate hikes are unlikely. In the medium term, this means dwindling real interest rates and rising market prices for many assets.

Increasing tax instead of sovereign debt as a way out of the coronavirus crisis was barely brought up at all during the IMF Annual Meetings. This came as something of a surprise. After all, there is little likelihood of the pandemic ending any time soon, and if a persistent policy of cheap money and rising government debt further drives up the price of real estate and securities then this would only exacerbate social inequality.


As at 19 October 2020