For much of the past three decades, policy space has been central to macroeconomic debate. It is commonly understood as the room for governments and central banks to act without triggering adverse market reactions, even before objective sustainability limits are reached.

Policy space has traditionally been assessed through familiar metrics: public debt ratios, debt sustainability metrics, fiscal dominance considerations and estimates of the natural rate of interest (r-star) under adverse scenarios. These metrics have proven useful, but they fail to explain a striking feature of the current global environment – economies with broadly similar macroeconomic fundamentals often experience radically different market reactions to comparable policy actions.

Some governments expand fiscally without triggering instability, while others face abrupt tightening of financial conditions. Some central banks can recalibrate policy with limited market backlash, whereas others are questioned almost immediately, sometimes within the same group of advanced economies.

These divergences cannot be explained solely by debt levels nor by static estimates of r-star. The missing variable is how global investors assess policy credibility in conditions of deep financial integration and how that assessment feeds back into market dynamics.

In financially open economies, policy space can no longer be treated as a structural attribute fixed only by accounting ratios. It is an endogenous, state-contingent outcome shaped by market beliefs about the coherence, consistency and institutional backing of policy choices.

From debt constraints to credibility constraints

The conventional narrative treats public debt as the primary constraint on macroeconomic policy. High debt is assumed to limit fiscal expansion and expose central banks to fiscal dominance, ultimately undermining price stability. Recent experience, however, challenges this linear logic.

Since the pandemic, advanced economy countries with elevated debt ratios have not faced uniform market reactions. Italy and Spain both emerged with high public debt and constrained fiscal space by conventional metrics, yet market perceptions diverged between the two economies over time. This reflects differences in perceived policy coherence, reform momentum and alignment with the broader euro area institutional framework, rather than debt arithmetic alone. In Italy’s case, developments in market pricing suggest credibility can be rebuilt, reinforcing the view that policy space expands or contracts as market assessments evolve.

An even starker illustration came from the UK in 2022. A sharp market repricing followed a fiscal announcement that was modest in scale relative to the country’s debt stock but perceived as lacking institutional coordination and a credible medium-term anchor. The resulting turbulence was driven by a sudden reassessment of policy credibility, not by immediate debt-sustainability concerns.

By contrast, other advanced economies have been able to absorb large fiscal expansions and sustained issuance with limited market disruption, reflecting confidence in institutional checks, policy coordination and the predictability of future adjustment. The lesson is clear: credibility has become a more binding constraint than debt itself. Crucially, however, credibility is not exogenous or fixed. It is continuously shaped by policy choices, communication strategies, institutional design and past interactions with markets – and ultimately by how those choices are interpreted and judged by investors.

Traditional metrics increasingly unreliable

Heightened financial integration has made credibility explicitly state contingent. The same policy action can stabilise markets in one context and destabilise them in another. Expansionary fiscal policy may compress risk premia if markets believe it supports sustainable growth, or it may trigger capital outflows if investors perceive policy incoherence or political fragility.

This helps explain why traditional metrics such as fixed estimates of r-star are becoming increasingly unreliable guides for policy. When market beliefs shift, the effective natural rate faced by a sovereign can move independently of domestic fundamentals. Yield curves may steepen not because inflation expectations are unanchored, but because investors reassess the credibility of the overall policy regime.

Japan offers a revealing counterpoint. Despite public debt levels far exceeding those of most advanced economies, markets have long tolerated accommodative fiscal and monetary policies. This reflects confidence in institutional continuity, a predominantly domestic investor base and the central bank’s role within a coherent policy framework. However, this tolerance is increasingly being tested, reinforcing the point that market confidence is conditional and forward-looking rather than mechanically tied to debt ratios.

Even the US, despite the privileges of reserve currency status, has seen markets become more attentive to political and fiscal signals. Episodes of fiscal brinkmanship and institutional polarisation have not undermined the dollar’s central role, but they have contributed to greater sensitivity in term premia and risk pricing at the margin. This suggests that reserve currency status confers insulation, not immunity, reinforcing the broader point that market tolerance remains conditional even for the system’s core issuer.

Emerging market experiences reinforce the same point. Countries with comparable debt levels, inflation profiles and external positions have faced sharply different market responses to policy adjustments. In Mexico, markets largely accommodated policy adjustments, allowing authorities time for gradual recalibration. By contrast, confidence in Brazil proved more fragile, translating into higher risk premia and tighter financial conditions despite no abrupt deterioration in fundamentals.

The different outcomes illustrate how markets can either amplify or dampen policy actions depending on credibility assessments. When credibility is strong, markets act as stabilisers, smoothing adjustment and extending the policy horizon. When credibility is weak, markets become amplifiers, compressing policy space where it is most needed.

Implications for policy-makers

For central banks, this environment complicates the task of normalisation and crisis management. The traditional focus on signalling reaction functions through interest rates and balance sheets must be complemented by close attention to how monetary policy interacts with fiscal strategy, financial stability tools and broader institutional narratives.

Credibility cannot be treated as a given. It is continuously tested by how policy choices are framed, coordinated and explained. Reliance on mechanically estimated neutral rates or pre-committed tightening paths risks misjudging market reactions when belief regimes change. This calls for discipline rooted in institutional clarity rather than mechanical rules.

For fiscal authorities, the lesson is equally stark. Debt sustainability is not just a function of primary balances and growth rates; it critically depends on whether markets believe fiscal expansion is purposeful, temporary when needed and embedded in a credible medium-term strategy. Fiscal policy that ignores market perceptions risks being self-defeating. The challenge is to credibly shape expectations.

The broader conclusion is that policy space should be reconceptualised. In a world of mobile capital and instantaneous repricing – increasingly shaped by algorithmic trading, real-time analytics and artificial intelligence-driven information processing – effective policy is about managing credibility dynamically so that markets stabilise rather than constrain policy when shocks hit. Analytical frameworks that treat credibility as a residual risk miss the central mechanism through which policy succeeds or fails in today’s financially integrated world.

Biagio Bossone is an adviser to international financial institutions and national central banks.

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