19 September 2017
There has been a vibrant debate about the desirability of increasing the coordination between fiscal and monetary authorities to combat large and persistent output gaps across the world. We have argued that despite widespread budget deficits and high public debt levels, there is headroom for governments to loosen fiscal policy, especially if concentrated in areas that boost the supply side of the economy. Indeed, with interest rates still so low, well-designed spending need not add to the net public debt ratio over the longer-term (see Table 1). Trump's election has offered a test case for how the market would react to a significant change in the fiscal outlook. This is partly because the election was unexpected (thus exogenous) and partly because the proposed fiscal stimulus was so large; the president was seeking corporate and personal tax cuts, and some infrastructure spending that were estimated to add between $3trillion and $7 trillion to debt over the next 10 years. Even taking the more conservative amount, this would imply a 2.1 percentage point increase in the general government deficit.
The initial bond market reaction to the election – US 10-year yields jumped 80 basis points in the six weeks after the election – has caused some to ask whether fiscal space may be limited after all. We think this argument is wrongheaded. Firstly, the magnitude of the market response was far from excessive, with the move broadly consistent with empirical estimates of the bond market impact of a permanent increase in the deficit equivalent to what Trump was proposing once the other factors that were simultaneously pushing up yields are taken into account. More importantly, Trump's proposals would primarily have pulled forward demand from the future rather than meaningfully increase potential output. As a result, the deficit would permanently, rather than temporarily increase if his policies are enacted, rates would be higher without the benefit of compensating higher output, and the Fed would have to bring forward and quicken its tightening cycle. A better constructed fiscal stimulus concentrated on supply-side enhancement would run a lower risk of triggering higher borrowing costs. Moreover, if yields were to rise it would more likely reflect optimism about future growth. That would be a breath of fresh air!