Limits to tinkering - the fiscal and monetary policy balance at risk

Since the global financial crisis, the worldʼs major central banks have engaged in extraordinary policy measures resulting in massive expansion of their balance sheets. With central banks running out of tools to stimulate the economy, the growing consensus is that another economic downturn will need a fiscal response. The key question is what form of fiscal activism we might see. One idea – similar to the case of Japan – is to combine increased fiscal spending with more ultra-accommodative monetary policy, such as quantitative easing (QE) or yield curve control.

There are still more radical proposals. One example is outright “helicopter money”, where central banks use their balance sheets to absorb the increase in government borrowing. This would be different from QE in that central banks would pledge to keep government bonds on their balance sheets indefinitely. Another idea that has gained traction recently is Modern Monetary Theory (MMT), which some argue is neither modern, monetary nor a theory. Under MMT, fiscal rather than monetary policy acts as the main stabilisation tool for the economy, while low interest rates are used to keep public finances sustainable.

While officially central banks retain their independence, the closer coordination with government raises questions about how true that is. We think outright regime shift towards alternative monetary/fiscal frameworks such as MMT is unlikely in the near-term. That said, we do expect fiscal policy to play a significantly bigger role, this at a time when global leverage is already close to historic highs, both to stimulate economic growth and to reduce income and wealth inequality. The degree and design of fiscal dominance will be important to monitor as it could have significant consequences for the economy and financial markets, including the insurance sector.

In a fairly benign scenario of closer policy coordination amid low inflation, a prolonged period of low interest rates would be the most likely outcome. By contrast, an outright regime change in the fiscal and monetary policy framework, such as MMT, could notably increase uncertainty around the inflation outlook and financial market stability. In the long-run, this could result in much higher inflation and interest rates, with broad repercussions on financial markets.

Potential impacts:

  • The economy and financial markets, including the re/insurance industry, could benefit if changes to fiscal and monetary policy stimulate growth and financial stability.
  • On the flipside, a policy shift could lead to a notable rise in uncertainty, causing higher financial market volatility and significant declines in asset valuations.
  • If central banks (are forced to) keep interest rates low to accommodate increased fiscal spending, the insurance industry would suffer, in particular life insurers.
  • Meanwhile, an unexpected and sustained increase in inflation – also a potential consequence of a regime change – would be harmful for the re/insurance industry, in particular for inflation-sensitive liability lines of business. At the same time, however, life insurers would benefit from a potential increase in interest rates as their liabilities typically have a longer duration than their assets.