Governments and central banks have thrown the entire kitchen, and half the house, at their economies since Covid-19 hit. Photo / 123RF
Governments and central banks have thrown the kitchen sink at their economies to try and offset the impact of Covid-19.
Better make that the kitchen sink, the entire kitchen, and half the house.
Fitch Ratings estimates that Government debt around the world will continue rising, reaching a forecast US$95 trillion next year, as policy-makers remain focused on responding to the economic consequences of the Covid-19 pandemic and its aftermath.
It's the kind of monetary and fiscal policy normally reserved for wartime and, for many, it seems to have worked.
Growth is back on track and inflation also looks to be on its way.
In New Zealand's case, parts of the economy — particularly construction — look to be overheating.
Miraculously, unemployment peaked just at 5.2 per cent in response to the pandemic, a far cry from the initial double-digit projections.
It's been a similar story around the world; a sharp contraction, followed by an almost equally as sharp bounce back. Measures that not so long ago would have been unthinkable — money printing — seem to have worked.
For the moment, normality in the capital markets looks to be some way off.
But what happens when the money taps are turned off?
What will the inflation response to unparalleled levels of fiscal and monetary stimulus be?
And how long will the inevitable inflation burst last.
These are the burning questions facing the capital markets.
Fitch believes there are risks in assuming the low current interest rate environment will be sustained indefinitely, especially if government debt continues to rise.
"Historical episodes of government debt reduction in developed markets are instead characterised by more mixed relationships between interest rates and economic growth," Fitch said.
"More importantly, the shared experience of almost all debt-reduction episodes is that governments run primary surpluses."
In Fitch's view, the future will be much like the past in this regard, and government debt reduction will eventually require fiscal adjustments.
ANZ markets strategist David Croy says the start of a normal scenario will be when the Reserve Bank, and other central banks, stop printing money via their quantitative easing programmes.
When that happens, he says monetary policy will go back to relying primarily on the official cash rate — with plenty of room to move policy in both directions. This could take a while, he says.
"We are expecting the Reserve Bank to start lifting rates in the second half of next year, but for them to get the cash rate to a point where they are comfortable that they have got flexibility in both directions — perhaps that's 2.0 or 2.5 per cent.
"At this point, we expect the cash rate to get to 1.25 per cent by the end of 2023. But even 1.25 per cent, up from the current 0.25 per cent, will still be very low. At 1.25 per cent, that does give them downside flexibility but it's not significant — not by any stretch."
Croy says a return to normal transmission for the financial markets is still some years away.
"We have got to get the cash rate back up to a level where it can genuinely go in either direction."
The New Zealand Government's finances will be less of an issue but globally, getting government books back to something more sustainable, with less reliance on printed money, will be a challenge.
"The legacy of that just can't be left to roll off as the bonds that they have bought come due.
"That process will have to be managed and that can take decades and, of course, there is always the risk of another crisis in the meantime.
"The amount of debt that has been built up domestically and globally has been significant," Croy says.
"It makes the whole world economy much more sensitive to higher interest rates."
When it comes to taking away the monetary punchbowl, uppermost in central bankers' minds will be the now-famous 2013 "taper tantrum" in the US.
The phrase describes the 2013 surge in US Treasury yields, resulting from the Federal Reserve's announcement of future tapering of its policy of quantitative easing — reducing the amount of money it was feeding into the economy.
The Fed's move saw bond yields spike higher — running counter to the their moves to keep them low — then recovered
An inflation surge is widely expected as the world recovers from Covid-19 and supply chain constraints continue to bite.
The question is how long will higher inflation last?
The consensus at the moment is that it will be transitory.
However, there is a risk that higher levels of inflation may last longer than policy makers think.
So what will it take for economies and markets to get back to normal?
ASB economist Mike Jones says in some ways we will not get back to the pre-Covid days.
"Certain parts of the economy will remain forever changed," he says.
"Vaccination is going to be the big leap forward in terms re-opening, and hence economic normality.
"Immigration, for example does, not look like it's going to return to anything like what it was pre-Covid."
He says aspects of the Tourism industry will not return to anything like pre-Covid levels.
"But there are parts of the economy that are already more or less back to where they were — such as the construction and housing market, and parts of the manufacturing sector.
"The helicopter view is that it will be a much more divergent, patch-work economy than where we were."
What needs to happen before markets can go back to normal?
"The big debate that is playing out nearly everywhere is whether the burst of inflation we are seeing is going to be more sustained or is it going to be temporary," Jones said.
"The answer to that will dictate when we see conditions start to normalise.
"We think (New Zealand) quantitative easing will be wound up some time in the first half of next year and then the withdrawal of interest rate stimulus will follow.
"But interest rates are going to remain below historical averages for some time," he said.
In the inflation debate, central banks are betting that a big lift in inflation won't last.
Conversely, markets are worried that inflation is going to be more sustained, for longer.
"We are somewhere in the middle," Jones says.
"Yes, the supply chain and commodity prices that we are seeing will probably prove to be temporary, but there is going to be a more sustained element as well, if you think that wage inflation must increase from here — as we do."
Jones said there does not appear to be any concern that that inflation genie — which bedevilled economies in the 1970s and 80s — would be let out of the bottle.
"I don't think that there is concern about hyperinflation, or that things will really run away.
"If anything, the bigger concern is that the burst of inflation that we are seeing is a bit of a false dawn, and that we head back to very low levels if inflation that we have become used to in the past five to 10 years. That's the higher concern.
"A lot of the drivers of that low inflation past are still around — whether it be globalisation, automation or low productivity growth.
"Those factors have not gone away.
"That's why you still have a lot of people in that transitory inflation camp.
"Central banks want to be sure the recoveries are going to be sustained before they remove the punchbowl.
"The lessons of the 2013/14 taper tantrum have been learned, and that's a good thing.
"The premature whipping away of the punchbowl is a real concern for central banks and that's why we have seen policymakers in the US stick to the 'patience' line so assertively.
"If the punchbowl gets removed because growth is accelerating and inflation is getting back to normal, then the market will be able to cope with that."
Jones says the extraordinary event of the last year or so is that the monetary and fiscal medicine has worked well.
The events of the last year have seen unprecedented intervention.
As Jones sees it, so too will be its unwinding.
OPINION: The challenges facing the Reserve Bank.