Central banks will not be able to control inflation without better fiscal policy, study finds

The exterior of the Marriner S. Eccles Federal Reserve Board Building is seen in Washington, DC, U.S., June 14, 2022. REUTERS/Sarah Silbiger/File Photo

JACKSON HOLE, Wyo., Aug 27 (Reuters) – Central banks will fail to control inflation and could even push price growth higher unless governments start playing their part with more prudent fiscal policies , according to a study presented to decision-makers at the Jackson Hole conference in the United States.

Governments around the world have opened their coffers during the COVID-19 pandemic to support economies, but these efforts have helped push inflation rates to their highest levels in nearly half a century, increasing the risk that rapid price growth continues.

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 for fighting inflation is not decisive in such a scenario.

“If monetary tightening is not supported by the expectation of appropriate fiscal adjustments, worsening fiscal imbalances lead to even higher inflationary pressure,” said Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed.

“As a result, a vicious cycle of rising nominal interest rates, rising inflation, economic stagnation and rising debt would occur,” the document states. “In this pathological situation, monetary tightening would actually spur higher inflation and trigger pernicious fiscal stagflation.”

On track for this fiscal year, which is expected to reach just over $1 trillion, the US budget deficit is expected to be well below previous forecasts, but at 3.9% of GDP it remains historically high and is not expected to decline. only slightly next year.

The euro zone, which is also struggling with high inflation, is expected to follow a similar trajectory, with its deficit hitting 3.8% this year and remaining high for years to come, especially as the bloc is set to suffer a recession from the fourth trimester.

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

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

“A more hawkish (Fed) policy would have cut inflation by just 1 percentage point at the cost of cutting output by about 3.4 percentage points,” the authors said. “That’s a pretty big sacrifice ratio.”

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 cut spending.

Reporting by Balazs Koranyi; Editing by Paul Simao

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