Study says central banks will fail to tame inflation without better fiscal policy

An exterior view of the Marriner S. Eccles Federal Reserve building in Washington, DC, US, June 14, 2022. REUTERS/Sarah Silbiger/File Photo

JACKSON HOLE, Wyo, Aug 27 (Reuters) – Central banks will fail to control inflation and could drive price growth higher unless governments start playing their part with wiser budget policies, according to a study presented to policymakers at the Jackson Hole conference. in the United States of America.

Governments around the world opened their coffers during the COVID-19 pandemic to prop up economies, but these efforts have helped push inflation to its highest levels in nearly half a century, raising the risk that rapid price growth will take hold.

Central banks are now raising interest rates, but the new study, presented Saturday at the Federal Reserve’s economic symposium in Kansas City, argued that the central bank’s reputation for fighting inflation is not critical in such a scenario.

“If monetary tightening is not supported by the expectation of appropriate fiscal adjustments, worsening fiscal imbalances will lead to increased inflationary pressures,” said Francesco Bianchi of Johns Hopkins University and Leonardo Melusi of the Federal Reserve Bank of Chicago.

“As a result, a vicious cycle of rising nominal interest rates, rising inflation, economic stagnation and increasing debt will arise,” the paper said. “In this pathological situation, monetary tightening would in fact drive up inflation and would trigger a detrimental fiscal stagflation.”

On track for this fiscal year to hit just over $1 trillion, the US budget deficit is set to be much smaller than earlier forecast, but at 3.9% of GDP, it’s still historically high and is expected to fall. marginally next year.

The eurozone, which is also struggling with high inflation, is likely to follow a similar trajectory, with its deficit hitting 3.8% this year and remaining high for years, particularly as the bloc is likely to suffer a recession starting in the fourth quarter.

The study argued that about half of the recent rise in inflation in the United States was due to fiscal policy and the erosion of beliefs that the government would conduct prudent fiscal policies.

While some central banks have been criticized for recognizing the problem of inflation too late, the study argued that even early interest rate increases would have been pointless.

“A more hawkish Fed policy would have reduced inflation by only one percentage point at the expense of cutting production by about 3.4 percentage points,” the report’s authors said. “That’s a very big sacrifice.”

To control inflation, fiscal policy must work in tandem with monetary policy and reassure people that instead of inflating debt, the government will raise taxes or reduce expenditures.

(Balazs Koranje report). Edited by Paul Simao

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