Calibrating monetary policy in recent years has been particularly challenging thanks to significant supply-side shocks to the global economy and considerable uncertainty regarding the demand-side implications. Whether or not monetary policy settings are now sufficiently restrictive in the world’s major economies is now being actively debated not least given recent indications that inflationary pressures have been building again. One point of contention is the seemingly blunt impact of monetary policy in both exacerbating, and then mitigating, inflation. This effect can be indirectly observed across advanced economies through the apparent breakdown of the Phillips curve relationship, which traditionally links unemployment and inflation. Over the past 20 years, as shown in Chart 4 below, this relationship typically yielded a negative correlation, in line with textbook theory. However, the post-COVID period has witnessed a significant divergence from this, a substantial disinflationary process has unfolded even as labor markets have remained very tight over the past two years.

An analysis of financial balances can be insightful in understanding these dynamics. Chart 5 below illustrates those balances for the three sectors that constitute the US economy: the private sector, the government sector, and the foreign sector. Each sector’s financial balance is determined by subtracting its total expenditure from its income. A financial surplus means the sector is accumulating financial assets, whereas a deficit indicates it is depleting assets (or increasing its borrowing) to fund its activity. Because these three sectors encompass all US economic activity, both domestic and international, their combined financial balances must equal zero.

A key point to note with respect to the US is the dramatic deterioration in the government’s financial balance in the post-COVID phase, initially prompted by private sector retrenchment (which subsequently reversed). Subsequently, however, COVID relief packages – which allowed the private sector to accumulate big saving reservoirs – coupled with large infrastructure investment programmes, have still left the government sector with an historically large deficit (amounting to 9.3% of GDP in Q3 2023). Against that backdrop, and partly thanks to that hefty fiscal policy support, the private sector has, on the whole, accumulated financial surpluses. These were depleted in the post-COVID recovery phase – which allowed the economy to maintain strong momentum – but were still sizeable, at around 4% of GDP, in Q3 2023. It is equally notable, however, that this private sector surplus has been climbing over the past 18 months. That could signal that monetary policy is restrictive not least as it has been accompanied by a smaller deficit on the foreign sector’s account as well.

An analysis of euro area financial balances is not as dramatic. The regional oscillations in each sector’s financial position have, in particular, not been as large as in the US (see chart 6). The government sector’s deficit position, for example, at 2.7% of GDP in Q3 2023, is little-changed compared with its pre-COVID level (of 3.1% of GDP) in Q1 2020. The private sector surplus, in the meantime, notwithstanding some initial post-COVID shocks, stood at 5.8% of GDP in Q4 2023, which compares with 2.5% in Q1 2020. This implies that the euro area economy as a whole has been in balance largely thanks to an offsetting increase in the foreign sector’s deficit, or putting that another way, in a higher current account surplus. The bottom line is that, at least on a regional basis, fiscal policy has been much less accommodative, and through a much higher private sector surplus, monetary policy is placing a big brake on the region’s economies as well.

Chart 6: Euro area financial balances