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According to the study, central banks will not be able to curb inflation without better fiscal policy

According to the study, central banks will not be able to curb inflation without better fiscal policy
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The exterior of the Marriner S. Eccles Federal Reserve Board Building is seen in Washington, DC, the United States, June 14, 2022. REUTERS/Sarah Silbiger/File Photo

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JACKSON HOLE, Wyo., Aug 27 (Reuters) – Central banks will fail to control inflation and could even boost price growth if governments don’t start playing their part with more prudent fiscal policies, one said Study presented to policymakers at the Jackson Hole conference in the United States.

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

Central banks are now raising interest rates, but the new study, presented at the Kansas City Federal Reserve’s Jackson Hole Economic Symposium on Saturday, argued that a central bank’s reputation as an inflation fighter is not crucial in such a scenario.

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“Unless monetary tightening is supported by expectations of appropriate fiscal adjustment, worsening fiscal imbalances will lead to even higher inflationary pressures,” said Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed.

“The result would be a vicious circle of rising nominal interest rates, rising inflation, economic stagnation and rising debt,” argues the paper. “In this pathological situation, monetary tightening would actually drive higher inflation and trigger harmful fiscal stagflation.”

The US budget deficit, which is expected to reach just over $1 trillion this fiscal year, will be far smaller than previously forecast, but at 3.9% of GDP it remains historically high and is expected to decline only slightly next year.

The eurozone, also struggling with high inflation, is likely to follow a similar path, with its deficit reaching 3.8% this year and staying at high levels for years, especially as the bloc is likely to enter a recession from the fourth quarter.

The study argued that about half of the recent surge in US inflation was due to fiscal policy and an erosion of belief in prudent government fiscal policies.

While some central banks have been criticized for being too late in recognizing the inflation problem, the study argued that even earlier rate hikes would have been futile.

“More restrictive (Fed) policy would have reduced inflation by just 1 percentage point at the cost of reducing output by about 3.4 percentage points,” the authors said. “That’s a pretty high casualty rate.”

To control inflation, fiscal policy needs to work with monetary policy and reassure people that instead of blowing away the debt, the government would raise taxes or cut spending.

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Reporting by Balazs Koranyi; Edited by Paul Simao

Our standards: The Thomson Reuters Trust Principles.

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