Growing government debt and pre-emptive interest rate rises threaten smooth global economic recovering The global economy is on course for a “smooth landing” from the inflation crisis this year, but government debts and any fast moves to lower interest rates risk derailing it once again, according to the Bank for International Settlements (BIS).
In its annual report[1], the BIS said: “The world economy appears to be finally leaving behind the legacy of the COVID-19 pandemic and the commodity price shock of the war in Ukraine. The worst fears did not materialise. On balance, globally, inflation is continuing to decline towards targets, economic activity and the financial system have proved remarkably resilient, and both professional forecasters and financial market participants see a smooth landing ahead.”
However, it warned that central banks needed to be wary when considering interest rate cuts. The BIS pointed out that inflation remained sticky in some key jurisdictions and that financial vulnerabilities and fragile fiscal positions remain.[2]
The report said: “Policy rates will need to stay high for as long as needed to re-establish price stability. A premature easing could reignite inflationary pressures and force a costly policy reversal – all the costlier because credibility would be undermined.
“Indeed, risks of de-anchored inflation expectations have not gone away, as pressure points remain. Macroeconomic and financial stability would be most vulnerable in this event. To guard against it, monetary policy needs to prioritise a sustainable return of inflation to target.”
Keeping an eye on government debt
At the same time, Agustín Carstens, the general manager of the BIS, has warned that rising government debt levels could disturb global financial markets.[3]
Globally, government debts are already at record levels and they threaten to range higher with the number of elections this year. France, Britain, Mexico and South Africa have already taken to the polls and the presidential campaign in the US continues apace. Elections carry risks for government debts because in order to win votes, governments often make election promises that necessitate higher spending in the first year or so in office.
Speaking to reporters, Carstens said: “[Governments] must cut short the rise in public debt and accept that interest rates may not return to the pre-pandemic ultra-low levels. We need a solid foundation to build upon.”[4]
He also warned that new governments shouldn’t make surprise moves, pointing to the turbulence on markets that followed the announcement of new budget plans from short-lived UK Prime Minister Liz Truss.
The new Labour government has been quick to reassure business and markets that their tenure will be fiscally responsible, but it has also promised to return the country to economic growth. Pursuing growth without any investment will be a difficult circle to square.
France is currently in limbo after no party gained a large enough majority to form a new government, but promises of new spending were made throughout the election.
Marine Le Pen’s National Rally (RN) said it would cut value-added tax (VAT) on energy, costing around €12bn in a full year. The RN also promised to put the retirement age back down from 64 to 62. The New Popular Front alliance said it would raise civil servant pay by 10%, provide free school lunches, supplies and transport, and raise housing subsidies by 10%.
In the US, incumbent president Joe Biden has promised tax increases on corporations and high earners, but also new spending on social programs and a wide range of efforts to combat high consumer costs like housing and college tuition. The Republicans, led by former president Donald Trump, are campaigning on tax cuts, along with curbs on immigration and higher tariffs for imports.
The catch-22
The difficulty for all government debt is that the cost of servicing it is also rising as interest rates remain high. The high debts were incurred during the time of historically low interest rates, making them much more manageable. Now the debt pile is starting to bite.
But with inflation fuelled in many major economies by a cost-of-living crisis, cutting spending to service high debt is a difficult pill for the electorate to swallow.
The good news is that central bank action on interest rates has managed to bring inflation rates back down again, more or less. The route to the “smooth landing” is in sight, but the balance to get there is somewhat precarious.
In a statement, the BIS said: “Two real economy pressure points stand out: fragile fiscal positions and subdued productivity growth… The overarching policy challenge is to complete the job of returning to price stability while at the same time keeping a firm eye on the longer term, thereby laying the foundations for sustainable and balanced growth.”[5]
[1] https://www.bis.org/annualeconomicreports/index.htm?m=157 [2] https://www.bis.org/annualeconomicreports/index.htm?m=157 [3] https://www.theguardian.com/world/article/2024/jun/30/soaring-government-debt-could-roil-global-financial-markets-warns-bis-director [4] https://www.theguardian.com/world/article/2024/jun/30/soaring-government-debt-could-roil-global-financial-markets-warns-bis-director [5] https://www.bis.org/publ/arpdf/ar2024e_ov.htm
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