The ECB’s decision last week to cut its policy rate and restart QE caused an unusual amount of disagreement, with a parade of central bank governors loudly voicing their opposition. Yet amid all the discord, the ECB governors were unanimous on one point: that fiscal policy should now take the baton from monetary policy as the main instrument to stimulate the economy. What is driving this increased focus on fiscal policy, and how likely is major fiscal stimulus?

Monetary policy side effects: Central banks have unleashed an extraordinary amount of monetary experimentation over the past decade, with over $11 trillion of QE and negative policy rates as low as -0.75%. They are now wondering how far they can push unconventional policies like negative rates, given the side effects such as impaired banking sector profitability. We don’t think we have yet reached the limits of negative rates. There is little evidence of cash hoarding to escape the negative return on large bank deposits. And for all the challenges to bank profitability, banks are still transmitting easy monetary policy to their customers via lower interest rates on consumer and corporate lending. All that said, we do think that pushing negative rates much lower than, say, -1% would probably require limits on cash holdings, quite a controversial step. Otherwise, the incentive to avoid negative rates by holding cash, yielding zero, would be too great.

Monetary policy effectiveness: The other main critique of unconventional monetary policy is that, while it may have been helpful in the depths of the crisis, it is at this stage only boosting asset prices, with little impact on growth or inflation. We do think that QE is still helpful, especially in easing funding costs in the Eurozone periphery. But we agree that fiscal policy would provide a more powerful boost to the economy. After all, monetary policy can only lower funding costs; it can’t force consumers, corporations and governments to spend. Fiscal policy directly increases spending in the economy.

An invitation from the bond market: Bond markets are inviting governments to spend. A case in point is the US, where the government deficit is rising with unemployment around its lowest in decades, precisely the opposite of the usual countercyclical approach to fiscal policy. Far from protesting at this, US Treasury bonds have flirted with all-time low yields over the past month. A different case is Italy, where bouts of political uncertainty have caused significant spikes in yields over the past few years. Even so, Italy’s debt has been steadily rising, while yields are also close to all-time lows.

Inflation expectations are low: For all their monetary inventiveness, central banks have failed to arrest the fall in inflation [in most countries] and inflation expectations [almost everywhere]. Quite apart from boosting growth, and – if well-designed – potential growth, easier fiscal policy could provide the impetus needed to reanchor inflation expectations closer to central bank targets. Some of the loudest calls for fiscal easing recently have come from advocates of money-financed fiscal expansion, based on Modern Monetary Theory [see the critique from my colleagues Ed Fitzpatrick and Kelsey Berro here – MMT: Short-term gain vs. Long-term pain]. But a more measured version of the same theme is simply that currently depressed inflation expectations provide scope for fiscal expansion.

Political constraints: In the near term, we see quite a few political constraints preventing governments from accepting the bond market’s invitation to spend. The US has a divided Congress heading into an election year. The Eurozone, and especially Germany, is constrained by constitutional borrowing limits, reflecting an ingrained aversion to government debt in many countries. We do expect some fiscal easing from Germany, but it is more likely to be a modest package, in line with the Federal government’s 0.5% of GDP wiggle room relative to the constitutional debt brake, than a fiscal bazooka. Japan is implementing some fiscal measures, but only as a counterpoint to a long-planned increase in sales tax. The UK is one developed economy where the fiscal narrative has clearly turned, and whichever government presents the next budget is going to turn the page on a decade of austerity. All told, that still leaves the onus on central banks to support the economy for now.

Watch elections, and Japan: In the medium term, we think the main policy response to the next recession will be fiscal stimulus, coupled with QE to absorb the resulting increased supply of government bonds. The trigger point for the shift could be economic weakness, or elections in which a platform of borrowing to spend at these very low yields proves a winning proposition. Japan’s economy and markets have long been a harbinger of what was to happen elsewhere. In recent years, the Bank of Japan has been hoovering up the Japanese government bond market, with limited success in pushing inflation higher. But importantly, instead of using this monetary support as an opportunity to spend more, the Japanese government has so far been reducing its deficit. In Japan and elsewhere, we will be watching closely to see when the baton is passed.