High inflation and the challenge of fiscal dominance

Article translated from the Informe Económico y Financiero #34 of the Esade Center for Economic Policy (EsadeEcPol) 

When I joined Esade from Banco de España in 2020, my first year as a lecturer was dominated by the challenge of explaining inflation to my students. Prices had remained stable for two decades, and my students had understandably relegated inflation to the bottom of the list of key economic challenges. However, just four years later, classroom discussions now focus on the negative consequences of high inflation, and I am faced with the challenge of explaining the possibility of nominal interest rates remaining at their lower limits for long time. 

This turnaround in inflationary dynamics has occurred surprisingly quickly. In this article, I show how current inflationary dynamics cannot be fully understood without considering the crucial role played by the interaction between monetary and fiscal policies. This long-ignored aspect has recently gained prominence, as evidenced by the policies of Argentina's new President Milei. His ‘Chainsaw Plan’ proposals to drastically cut public spending include closing down the central bank and dollarizing the economy. These proposals are aligned with the idea of defeating inflation by preventing fiscal policy from interfering with monetary policy. 

Inflation’s monetary nature

Inflation is traditionally considered a monetary phenomenon, where money supply and interest rates reflect economic conditions. The underlying assumption focuses on the direct relationship between the cost of credit and demand for consumption and investment. For example, an increase in interest rates reduces demand and so lowers inflation. Central bank decision-making depends on past and current demand in relation to the monetary base, as well as past and current interest rates. 

The role of central banks has expanded beyond simply adjusting monetary variables to influencing public perception and market expectations

Pioneering work by economists such as Edmund Phelps in the 1960s revealed that a crucial aspect of this relationship occurs paradoxically ‘in the future’, or, more precisely, in the expectations of firms and households. This recognition led to a reconfiguration of the paradigm so that central banks determine money supply and interest rates to control expectations about inflation. This task can only be achieved with an independent central bank that is clearly committed to its policies. Phelps' work was decisive in this change of approach, arguing that inflationary expectations play a fundamental role in the economic decisions of consumers and investors. Monetary policy shifted away from reacting to specific economic indicators and towards managing expectations. Accordingly, the role of central banks expanded, and they assumed the task of adjusting monetary variables, as well as influencing public perceptions and market expectations. An independent and credible central bank is crucial for managing these expectations and ultimately controlling inflation. Stabilizing prices within this framework is primarily seen as a task for central bankers. 

Fiscal influences on inflationary dynamics

However, as I mentioned at the beginning, inflationary dynamics depend on monetary and fiscal policies. One way in which this relationship can be seen is through direct government interference in the decisions of central bankers, limiting their independence, and using interest rates to achieve political goals. An example is the pressure applied by President Nixon on US Federal Reserve Chairman Burns in 1971. A recent article by Thomas Drechsel reports how Burns wrote in his diary that Nixon would do anything to get reelected and urged him to ‘start expanding the money supply and predicting disaster if this didn’t happen’. Although interactions between the American president and the Fed chair were frequent in the Nixon era, such behavior was not unique to his administration. Drechsel shows that political interference can be of decisive, since increasing political pressure by 50%, as Nixon did for six months, increased American prices by more than 8%.  

Fiscal policy can influence monetary policy, even if the central bank is completely independent and the government does not try to interfere

Similar patterns are seen in President Trump's tweets attacking Fed Chairman Jerome Powell in 2018, calling on him to cut interest rates. An article by Francesco Bianchi, Thilo Kind, and Howard Kung concludes that Trump's tweets lowered expectations for Fed fund rates and caused share prices to rise. You do not have to go far back in time to find another example. In 2021, Turkish President Erdogan fired the central bank governor, who had cited rising inflation to oppose cuts in interest rates. Erdogan wanted interest rates cut to ease access to credit and strengthen his support before the 2023 general election. Erdogan then appointed a new governor who duly cut the rates, and inflation leapt from 20% to over 80%.  

But fiscal policy can influence monetary policy even if the central bank is completely independent and the government is not interfering. Consider the following example. Faced with high inflation, a central bank raises interest rates to limit price growth, and this causes a cost-of-living crisis. In response, the government introduces an expansionary fiscal policy to help households and businesses. These groups then use the expansionary resources to support their spending, thereby stimulating demand and increasing inflationary pressure. Thus, the central bank is forced to further raise interest rates. If this vicious circle of interest rate increases and fiscal support continues, we face a situation of persistently high inflation, a monetary authority that loses credibility in its efforts to maintain low and stable inflation, and limited room for maneuver for the government (whose expansionary fiscal policy has probably increased the deficit and debt). This mirrors in some ways what has happened over the past two years. I am certainly not advocating withdrawing support for the most vulnerable during periods of high inflation. However, I am emphasizing that achieving a soft landing from high to low and stable inflation, with minimal losses to economic activity, is a complex task that requires a joint effort by monetary and fiscal authorities. Quickly achieving a low and stable inflation rate with minimal fallout in economic activity, boosts the credibility of the central bank and produces a political dividend for governments.  

Fiscal dominance 

Another scenario in which government fiscal policies indirectly limit the options of an independent central bank is fiscal dominance. This phenomenon occurs when a country's debt and deficit are so large that monetary policy cannot control inflation. High interest rates in an environment of chronic deficits can aggravate inflation, or spark a sovereign debt crisis, which leads to uncontrolled inflation (hyperinflation or deflation). High levels of public debt force central banks to adopt diluted policies that cannot effectively stabilize inflation. 

It is important to maintain sustainable public finances to ensure the effectiveness of monetary policy in controlling inflation

In the current global economic landscape, we are facing a critical situation with public debt representing 92% of world GDP (according to the IMF). This level of indebtedness is three times higher than the mid-1970s and is unfolding in a context of acute political polarization that severely limits the margin for fiscal austerity. In this scenario, a fundamental threat arises: fiscal dominance and its impact on the delicate balance between fiscal and monetary policy. When a central bank is constrained by fiscal pressures, it is often forced to keep interest rates artificially low, and this further feeds the inflationary spiral. This situation endangers economic stability and undermines the central bank's credibility, especially if financial markets believe the central bank has become subordinated to the government's fiscal needs, thereby eroding confidence in its ability to control inflation. 

Where is the empirical evidence on the role of fiscal dominance? It is suggested in a paper by Francesco Bianchi and Cosmin Ilut that the Great Inflation of the 1970s in the United States was the result of a dysfunctional interaction between monetary and fiscal authorities. During the 60s and 70s, monetary policy was tailored to fiscal requirements, and this led to high levels of inflation. The change of direction under Paul Volcker at the Federal Reserve was crucial, but inflation only began to decline when a more sustainable fiscal policy was adopted. This analysis highlights why earlier attempts to control inflation failed and emphasizes that a successful strategy requires strong fiscal support. In a related study, Roberto Barro and Francesco Bianchi extend this view and conclude that fiscal expansion in OECD countries since 2019 has been a key driver behind the recent rise in inflation. These findings support Nobel laureate Tom Sargent's assertion that ‘sustained high inflation is always and everywhere a fiscal phenomenon, in which the central bank is a monetary accomplice’. 

For these reasons, fiscal dominance is a major threat to economic stability and requires careful coordination between fiscal and monetary authorities. This threat underscores the importance of maintaining sustainable public finances to ensure that monetary policy can effectively control inflation. However, there is a way to control the harmful effects of fiscal dominance, even in times of exceptional shocks such as the Covid-19 pandemic. Such an approach requires a coordinated fiscal and monetary strategy that produces a controlled increase in inflation to erode a specific fraction of the debt. As part of a coordinated strategy, the fiscal authority can introduce an emergency budget with no provisions on how it will be balanced, while the monetary authority announces a temporary increase in the inflation target to accommodate this emergency budget. This coordinated strategy increases the effectiveness of the planned fiscal stimulus in response to the pandemic, while enabling the central bank to steer a course for a prolonged period of below-target inflation. This strategy results in only moderate levels of inflation by separating long-term fiscal sustainability from short-term policy intervention. 

However, the implementation of such a strategy within the eurozone is even more challenging, as one central bank needs to work with multiple fiscal authorities. One solution would be to take back control of public finances at the national level (a new European fiscal compact — with all of its numerous limitations — is a step in the right direction), and eventually define a common fiscal authority that systematically issues Eurobonds in response to large and unexpected shocks, such as a pandemic, war, or a financial market collapse, in support of the independent fiscal decisions of each member state. Such a coordinated strategy could separate short-term stabilization policies from long-term fiscal sustainability, harmonize fiscal policy within the eurozone, and avoid the dangers of fiscal dominance while enabling the European Central Bank to credibly achieve a stable rate of inflation.