Today marks ECB President Mario Draghi’s last monetary policy meeting before the presidency is passed on to Christine Lagarde at the end of the month.
Despite the “whatever it takes” speech of July 2012 that marks Draghi’s legacy, European economies are still clouded with a weakening economic outlook and struggling with an inflation level that is below the 2% target.
Yield curves, which plot bond yields at different maturities, continue to move lower and flatter, as markets price in a lower for longer rate environment. With interest rates already below zero and the restarting of the asset purchase program last month, the case for fiscal spending to boost economies has climbed up the policy agenda across the Euro area.
By definition, fiscal policy is the use of government spending and tax policies to influence the economic environment. Governments increase spending or cut tax rates to stimulate the economy and decrease spending or raise taxes to slow economic growth.
When it comes to analysing fiscal policy, the change in fiscal spending is more important than the actual level. For instance, an increase in the budgetary deficit is more representative of a stimulus than a continuous fiscal deficit. Moreover, the government’s budget automatically moves in tandem with the economic environment. In a booming economy, the budget deficit naturally falls as tax revenues increase. Meanwhile, in a weaker economic environment, deficits tend to rise as government spending on unemployment benefits increase and tax revenues decline. Thus, the deliberate changes in the Budget are what matters the most.
Combining looser fiscal policy with the current accommodative monetary policies should create the most effective stimulus for economic growth. This combination can create synergies beyond the basis of economic theory.
Accommodative monetary policy creates an opportunity for countries to take advantage of lower borrowing rates and increase government spending to invest in social and infrastructure capital. This creates additional fiscal space for certain economies. In turn, synergies are created as this would increase the supply of eligible government bonds for the ECB asset purchase program.
Some governments, including France, have recently announced some additional fiscal loosening in their budget. However, with the majority of European countries already exceeding the current fiscal rules, a sizable fiscal expansion across the euro area is not likely to happen, at least in the near term. The 3% deficit and 60% gross debt relative to GDP ceiling prevents a significant fiscal boost from occurring and highlights the need for more flexibility. There is also scope to allow countries undergoing structural reforms to delay the pace of debt reduction.
Disclaimer: This article was issued by Rachel Meilak, CFA Equity Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.