Central banks won’t be able to tame inflation without better fiscal policies, study says

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

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JACKSON HOLE, Wyo., Aug. 27 (Reuters) – Central banks won’t control inflation and could even push price growth unless governments play their part with more cautious fiscal policies, according to a study presented to policymakers at the Jackson Hole Conference in the United States.

Governments around the world opened their coffers during the COVID-19 pandemic to prop up economies, but those efforts have helped inflation climb to its highest level in nearly half a century, raising the risk of rapid price growth will be anchored.

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

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“If monetary tightening is not supported by the expectation of appropriate fiscal adjustment, the worsening fiscal imbalances will lead to even greater inflationary pressures,” 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 mounting debt would ensue,” the paper argued. “In this pathological situation, monetary tightening would actually lead to higher inflation and cause pernicious fiscal stagflation.”

On track to hit just over $1 trillion this fiscal year, the U.S. budget deficit will be much smaller than previously forecast, but at 3.9% of GDP, it remains at an all-time high and will decline only marginally next year. .

The eurozone, which also struggles with high inflation, is likely to follow a similar path, with a deficit of 3.8% this year and high for years to come, especially as the bloc is likely to enter a recession from the fourth quarter.

The study argued that about half of the recent rise in US inflation was the result of fiscal policies and an erosion of the belief that the government would adopt prudent fiscal policies.

While some central banks have been criticized for failing to recognize the inflation problem too late, the study argued that even past rate hikes would have been futile.

“A more aggressive Fed policy would have cut inflation by just 1 percentage point at the expense of manufacturing by about 3.4 percentage points,” the authors said. “This is a pretty big sacrifice ratio.”

To keep inflation in check, fiscal policy must go hand in hand with monetary policy and reassure people that instead of inflating debt, the government would raise taxes or cut spending.

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Reporting by Balazs Koranyi; Editing by Paul Simao

Our Standards: The Thomson Reuters Trust Principles.

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