Strategy Focus - Monetary policy and the financing of public sector deficits

During the pandemic, developed economies put in place economic policies that were unprecedented in their scale. The financing of such large fiscal packages depended in part on central banks helping out with asset purchase programs. This policy mix resulted in major financial transfers between economic agents, resulting in a sharp rise in government debt, a similar surge in household and corporate savings, and a new and important role for central banks in funding the government.

Now, with the return of inflation pressures, central banks are winding down their support and governments are struggling to normalize their fiscal policy. At first sight, it is hard to see how public debt can continue to increase at the current pace when central banks are shrinking their balance sheets. But this bean-counting approach with its assumptions that finance moves in closed loops does not tell the whole story. Other factors are at play:

- Central banks are providing less liquidity, but governments continue to create liquidity by issuing new debt. This cash continues to fuel demand for financial assets among the private sector and foreign investors.
- The bond market is also a self-regulating mechanism and has adjusted prices to reflect the changes. As interest rates have risen investors are increasing their bonds holdings into their portfolios.
- Cross-border financial balances are shifting but an influx of plentiful savings from Asia, the Gulf and Europe continues to sustain demand for financial assets, particularly bonds.

That said, the new monetary policy of higher rates for longer undoubtedly puts greater pressure on the financing of public deficits and hence on interest rates, raising two kinds of risk:

- Risk of financial stress. A slide in confidence could put pressure on the rates of certain countries’ debt, as the United Kingdom found out in autumn 2022. At this stage, we see limited risk of this happening in the world's major countries. Central banks can always adjust their balance sheets to head off excessive tensions. In the euro area there is a higher risk to specific countries, such as Italy and France, where public debt ratios are projected to continue to increase rapidly. The framework provided by the single currency has however been beefed up since the 2011-12 euro debt crisis and should be able to handle any turbulence of this kind.
- Risk of sharp budget cuts. Countries at risk of losing investors’ confidence could be tempted to radically tighten fiscal policy. Any such policy retrenchment would worsen the economic slowdown. We think this risk is particularly relevant in the euro area.

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