According to a research presented to decision-makers at the Jackson Hole conference in the United States, central banks will fail to control inflation and may even drive price increases higher unless governments start contributing with more responsible budget measures.
To support economies during the COVID-19 pandemic, governments all around the world emptied their coffers, yet this contributed to inflation rates reaching their greatest levels in almost 50 years, increasing the likelihood that fast price growth may become entrenched.
The new study asserted that a central bank’s reputation for combating inflation is not important in a situation where central banks are hiking interest rates, which was presented on Saturday at the Jackson Hole Economic Symposium of the Kansas City Federal Reserve.
“If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the deterioration of fiscal imbalances leads to even higher inflationary pressure,” said Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed.
“As a result, a vicious circle of rising nominal interest rates, rising inflation, economic stagnation, and increasing debt would arise,” the paper argued. “In this pathological situation, monetary tightening would actually spur higher inflation and would spark a pernicious fiscal stagflation.”
The US budget deficit is expected to total just over $1 trillion this fiscal year, which is far less than had been anticipated. However, at 3.9 percent of GDP, it is still historically large and is only expected to slightly decline in the following year.
With its deficit expected to reach 3.8% this year and remain high for years (especially given that the euro zone is expected to experience a recession beginning in the fourth quarter), the euro zone, which is also dealing with high inflation, is likely to take a similar course.
According to the study, fiscal policy and a decline in trust in the administration’s ability to implement responsible fiscal measures were to blame for around half of the recent spike in US inflation.
Even earlier rate hikes, according to the report, would have been ineffective. Some central banks have been criticised for recognising the inflation problem too late.
“More hawkish (Fed) policy would have lowered inflation by only 1 percentage point at the cost of reducing output by around 3.4 percentage points,” the authors said. “This is a quite large sacrifice ratio.”
Fiscal and monetary policy must cooperate in order to contain inflation, and the public must be reassured that tax increases or spending cuts will be implemented in place of inflating away debt.
