The fiscal-monetary tango

The pandemic years called for policy reinforcement; the post-pandemic aftermath will call for policy prioritisation

- SAJJID Z CHINOY

The past two years have seen the largest coordinated global fiscal-monetary stimulus since World War II. The early and aggressive policy response has clearly mitigated the economic impact. The global output gap took 36 quarters to close after the 2008 crisis. Remarkably, this time it's on course to close in just 14 quarters, albeit with large regional variations. But injecting stimulus is the easy part. The challenge is in calibrating the withdrawal. Car accidents rarely occur during acceleration; instead it's the inability to brake in time.

The Fed is finding out the hard way. A gargantuan US stimulus has kept aggregate demand elevated even as disrupted global supply chains are taking time to unwind.

But the real supply-side challenge for the Fed will lie elsewhere: labour markets. The US is still almost four million jobs shy of pre-pandemic levels. Yet, the unemployment rate has plummeted from 7 to 4 per cent in a year because labour force participation has remained depressed. A myriad of pandemicinduced behavioural changes may explain that, but the upshot is a very tight labour market with wages growing at 5 per cent. This has triggered a hawkish pivot from the Fed, with markets now expecting four rate hikes and balance sheet tightening this year. But markets still remain too sanguine that policy rates won't need to rise to anywhere near "neutral”. There lies the risk.

The more the labour market or SO inflation surprises, the more yields will need to reprice and the greater the reverberations felt around the world.

Unlike 2013, the concern is not of a Taper Tantrum. Instead, the worry is that the spillover from US rates drives a premature tightening of monetary conditions in many emerging markets that can ill-afford it, given their more patchy and incomplete recoveries from the pandemic.