Join our community of smart investors

The policy tightening

One justification for low interest rates is that fiscal policy will be tightened significantly. This could be good news in the short-term for investors, but not perhaps in the longer-term.
September 20, 2021

Many of you are exasperated by the Bank of England’s reluctance to raise interest rates in the face of rising inflation. There is, though, an under-appreciated reason for this reluctance. It is that the job of tightening policy is going to be done by fiscal rather than monetary means.

The OBR forecasts that cyclically-adjusted net borrowing will fall from 9.7 per cent if GDP this year to 3.3 per cent in 2023-24. That’s a tightening of 6.4 percentage points of GDP, more than anything we saw under the Thatcher or Cameron governments. It’ll be achieved by a combination of spending restraint and tax rises; the OBR has forecast that the share of taxes in GDP will rise to its highest since the late 1960s – and that was before the recent announcement of a hike in national insurance contributions.

This squeeze might not be motivated by a desire to hold down inflation, but that will be its effect. Higher interest rates reduce inflation by depressing demand. But fiscal policy also reduces demand and so cuts inflation.

And it does so significantly. Bank of England economists estimate that a percentage point rise in Bank rate cuts output by around 0.6 per cent. If the fiscal multiplier is around one, this implies that the fiscal tightening over the next two years is equivalent to a rise in interest rates of over ten percentage points.

From this perspective, it’s easy to see why the Bank is loath to raise rates. It’s because the government is doing the job of fighting inflation instead.

Should it? In principle, in the absence of shocks to demand of the sort we saw last year, any mix of monetary and fiscal policy could achieve the same path for output and inflation, be it increased government borrowing offset by high interest rates or lower borrowing offset by low rates.

The impact on asset prices, however, is not the same. For a given path of aggregate demand, asset prices are higher when interest rates are lower. This is simply because lower rates mean that investors discount future cash flows by less causing the net present value of those flows to be higher. A tight fiscal/loose money policy mix thus supports high asset prices.

This does more to sustain house prices than equities: real interest rates are more strongly correlated with the house price-earnings ratio than with equity valuations.

For many of us home-owners this is no great benefit because housing is not wealth. It might, however, be bad for younger people who are forced to rent because they cannot raise a deposit. This is because renting offers less security and forces one into being dependent upon somebody else: as Mrs Thatcher recognised, home ownership has non-pecuniary advantages.

There is, however, another cost of cheap money – the fact that it might not last. When the fiscal tightening stops, rates might well rise significantly. Which would kick away the support for house prices. Whilst this is neither here nor there for most of us, it is a threat to those landlords who have borrowed heavily and are dependent upon ever-increasing house prices. Cheap money is a drug to which one can become addicted – but what happens when the drug is taken away?