Monetary policy settings across countries only make sense by also considering the fiscal context.
In 2020, the world faced the common shock of the pandemic. Initially similar consequences later diverged under the influence of very different policy responses. Roll forward to 2024, and the signs of that divergence are even starker.
Australia, for example, was late to the inflation surge because, compared with our advanced economy peers, we were later to open up after the pandemic. While the initial bounce back in demand returned consumption back to its pre-pandemic trend, the pandemic-era fiscal support that enabled this expired. Consumption per capita declined nearly 2½% over 2023 in Australia. It has been noticeably weaker than in peer economies, where it has generally been soft but broadly flat in level terms.
The United States, by contrast, has been an outlier on the other side. There, consumption per capita has been rising steadily.
The difference stems largely from the very different fiscal policy stances. In Australia, the federal government is running a surplus and likely to record another surplus in the current financial year. Some of this reflects windfall gains associated with high commodity prices but it is also due to the way tax operates in Australia. Personal income tax brackets are not indexed, and partly as a consequence of the surge in inflation, fiscal drag has resulted in the share of household income going to income tax reaching an historical high in the second half of 2023. (A graph showing this is in our April Market Outlook publication. (PDF 528KB))
By contrast in the United States, the federal government is running a budget deficit of around 6% of GDP, with no consolidation in sight or even being seriously discussed. Income tax brackets are indexed to the CPI, so American households are not seeing that drag from higher tax payments. Together with the fact that average mortgage rates paid have risen far less in the United States, macro policy is barely touching the sides for the US consumer.
The overarching lesson here is that monetary and fiscal policy are particularly powerful when they are working in the same direction. This was true in both Australia and the United States during the peak of the pandemic, when both governments managed to more than fill the hole in household and small business incomes created by lockdowns. It is also true in Australia now, though working in the opposite direction. Meanwhile, despite higher policy rates, growth in the United States has outstripped its peers among advanced economies. One reason for this is that fiscal policy is still boosting the level of demand.
The situation in some other advanced economies is, as consumption developments would suggest, somewhere in the middle. Fiscal support during the pandemic was not quite as fulsome in Europe and Japan as in the Anglosphere. More recently, it has also lain between the extremes of Australia and the United States.
This fiscal context goes a long way towards explaining recent differences in the perceived adequacy of monetary policy tightening. While there is still a body of opinion holding that the RBA will not cut rates until 2025, a number of customers overseas (I am writing this from London) are more likely to ask what would trigger the RBA to cut rates earlier than our current call for a late-September timing.
Meanwhile in the United States (and New Zealand, where fiscal policy also remains expansive), the tendency has been for market pricing of the first rate cut to be pushed out. On the other side, some commentators (for example as represented in the Geneva Report issued late last year) are concerned that the ECB and some other central banks are on the cusp of a policy mistake by keeping policy too tight.
All of this is to say that simple cross-country comparisons of current levels of the policy rate, or with estimates of neutral rates, are not the whole story. Aside from the uncertainties around estimating the neutral real rate of interest, there are other things going on that need to be taken into account. The size and shape of fiscal support is one major divergence that should not be ignored.
On top of influencing the required stance of monetary policy, differing fiscal strategies might influence monetary policy choices in other ways.
Recall that several central banks, including the Federal Reserve, RBNZ and Bank of Canada, have decided to retain a ‘floor system’ operational model, with excess bank reserves on the central bank’s balance sheet dragging down the overnight cash rate towards the rate paid on those reserves. Meanwhile the RBA, ECB, Bank of England and the Riksbank in Sweden have chosen the less expansive ‘ample reserves’ option.
These groupings start to make sense when we consider that the floor system group mostly have more expansionary fiscal policy than the ‘ample reserves’ group. (Central government deficits in the UK and Canada are both increasing but Sweden, like Australia, is running fiscal surpluses that were not previously forecast.)
The central banks are not consciously choosing to accommodate loose fiscal policy. Rather, they are assessing how large their bond holdings can be without degrading market functioning by ‘cornering’ the market. This naturally depends on the likely future size of the government bond market. Market size therefore shapes the view of the risks and costs of adopting a floor system of excess reserves, and so the choice between regimes. It is just another dimension of the principle that both policies need to be analysed in the context of the settings of the other policy.
