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For decades, the economics consensus has been that fiscal and monetary policy should be largely separate. Governments should provide public services, foster an acceptable distribution of resources and ensure the sustainability of their public finances. Central banks should then set interest rates to maintain price stability. It is a neat and tidy model.
The principal of separation between fiscal and monetary policy always had an important exception, of course, which is triggered in a serious economic downturn. When interest rates fall so low that monetary policy becomes ineffective, central banks need the power of fiscal stimulus to prevent a depression. The global financial crisis of 2008-09 and the initial Covid crisis of 2020 showed these were not mere theoretical possibilities.
That thinking feels very passé. Now that interest rates in most advanced economies have risen towards normal levels, calls for governments to act in concert with central banks are louder than ever. In the past three months, the IMF, the OECD and the Bank for International Settlements have each demanded countries raise taxes or limit public spending to curtail demand and reduce inflationary pressures, thereby helping monetary policy to do its job.
The economic logic is compelling. Fiscal policy can be powerful and rapid in bringing demand down to meet the reduced supply capacity wrought by the Covid pandemic and the energy crisis. Higher taxes allow governments to spread the burden of interest rate rises more widely — rather than watching those with the highest debts pay the largest price. Getting governments involved in price stability is therefore more effective and fairer.
The BIS last month picked up on an additional benefit of tighter fiscal and looser monetary policy: the current scenario, it said, was testing the boundaries of “the region of stability”, with high interest rates making a financial crisis much more likely. Last year’s turmoil in UK pension funds and this year’s among US regional and Swiss banks was a warning of what might arise if governments did not step up to the plate, it added.
So far, so clear. Governments should help their central banks by borrowing less at a time of high inflationary pressure. But as the IMF acknowledged last week, it’s not quite that simple. In an important paper at the European Central Bank’s annual forum, fund staff presented evidence that the substantial energy subsidies implemented across Europe last year appear to have both lowered peak rates of headline inflation and kept future price rises closer to the ECB’s 2 per cent target.
The research results directly contradicted the IMF’s own advice; it was brave of its chief economist, Pierre-Olivier Gourinchas, to present the findings himself. Having studied the experience of energy subsidies, the fund now believes that their direct effect in bringing down headline inflation and taking the heat out of a European wage price spiral outweighs the fiscal stimulus involved in capping petrol, gas and electricity prices.
Gourinchas was clear that this was a specific result caused by slack in eurozone labour markets, rather than marking the IMF’s conversion to the benefits of price controls or subsidies. He added that the jury was out on the inflationary effects of the UK’s energy price subsidies because the labour market there was so tight.
Regardless of the precise estimates, the important thing to note is that we are living in a new, much messier era. Governments clearly have a role in managing inflation — in a slump, this means stimulus; when inflation is high, it means higher taxes or austerity, and very occasionally price-distorting subsidies. Central banks are still ultimately in control of inflation with monetary policy but the idea that governments can pass the buck is past its sell-by date.