How fiscal restraint can help fight inflation

Government support was essential to help individuals and businesses survive pandemic-related lockdowns and support economic recovery.

When inflation is high and persistent, broad-based fiscal support is not warranted. Most governments have already reduced their support for the pandemic, as reported in our October Financial Review.

While many people are still struggling, governments should continue to prioritize helping the most vulnerable to meet soaring food and energy bills and cover other costs, but governments should also avoid d to increase aggregate demand which risks pushing up inflation. In many advanced and emerging economies, fiscal restraint can reduce inflation while reducing debt.

Fiscal consolidation, debt limitation

Central banks are raising interest rates to dampen demand and contain inflation, which in many countries is at its highest level since the 1980s. Since rapid price increases are costly for society and detrimental stable economic growth, monetary policy must act decisively.

If monetary policy has the tools to control inflation, fiscal policy can clean up the economy in the long term through investments in infrastructure, health care and education; a fair distribution of income and opportunities through an equitable tax and transfer system; and the provision of basic public services. However, the overall fiscal balance affects demand for goods and services and inflationary pressures.

A lower deficit cools aggregate demand and inflation, so the central bank does not need to raise rates as much. Moreover, with tight global financial conditions on budgets and public debt ratios above pre-pandemic levels, reducing deficits also addresses debt vulnerabilities.

Conversely, fiscal stimulus in the current high inflation environment would force central banks to apply the brakes harder to curb inflation. In an environment of high public and private sector indebtedness, this can increase risks to the financial system, as described in our Global Financial Stability Report in October.

Demonstrate alignment

In this context, policymakers have a responsibility to provide strong protections to those who need them, while reducing elsewhere or generating additional revenue to reduce the overall deficit. Fiscal responsibility – or even consolidation if necessary – shows that policymakers are aligned against inflation.

When fiscal adjustment is sustained, ideally through a medium-term fiscal framework that outlines the direction of policy over the next few years, it also responds to looming pressures on debt sustainability. These include aging populations in most advanced and several emerging economies, and the need to replenish buffers that can be deployed during future crises or economic downturns.

In our research, we use a stylized two-country model (where the “home economy” can be the United States or a group of advanced economies). We are looking at two different approaches to curbing inflation. The first relies exclusively on monetary tightening to cool the overheated economy, while the second involves fiscal consolidation. Both are constructed to have similar effects on economic growth, and each is effective in reducing inflation. In the first case, higher interest rates and weaker growth contribute to the increase in public debt. Meanwhile, the currency is appreciating as higher yields attract investors.

In the second approach, fiscal tightening dampens demand without the need to raise interest rates, so that the real exchange rate depreciates. And with lower debt servicing costs and lower primary deficits, public debt is falling. The appreciation of the real exchange rate under a more restrictive monetary policy implies that inflation falls a little more, but this difference would decrease if more countries pursued these policies.

In the face of high food and energy prices, governments can improve their fiscal position by shifting from generalized support to helping the most vulnerable, ideally through targeted cash transfers. Since supply shocks are long-lived, attempts to limit price increases through price controls, subsidies, or tax cuts will cost the budget dearly and ultimately not be effective. Price signals are essential to promote energy conservation and encourage private investment in renewable energy.

The desirable fiscal stance and the measures that underpin it will depend on country-specific circumstances, including current inflation rates and longer-term considerations such as debt levels and development needs. In most countries, higher inflation strengthens the case for fiscal discipline, calling for raising revenue or prioritizing spending that preserves social protection and growth-enhancing investments in human or physical capital.

International sizes

In the United States, the disinflation of the early 1980s under Federal Reserve Chairman Paul Volcker illustrated the challenges of controlling inflation. Inflation had become entrenched at high levels and fiscal policy was expansionary. The Fed had to raise its rates sharply to contain inflation, causing a collapse in real estate investment and a historically significant appreciation of the dollar. Manufacturing has been hit hard, leading to calls for trade protectionism.

This historic episode is relevant for many countries facing similar challenges today. A more balanced removal of stimulus measures, including fiscal restraint, can reduce the risk that parts of the economy, especially those most sensitive to interest rates, will be disproportionately affected or that the currency will fluctuate sharply. exacerbate trade tensions.

It would also reduce the risk globally. Less abrupt increases in interest rates would imply a more gradual tightening of financial conditions and mitigate risks to financial stability. This would tend to limit negative spillovers to emerging market economies and reduce the risk of sovereign debt distress. Avoiding strong appreciation of the US dollar or other major currencies would also reduce pressure on emerging markets borrowing in those currencies.

As many central banks tighten policy in response to the large and persistent rise in global inflation, the policy mix matters. Fiscal moderation will reduce the cost of getting inflation back to target quickly, compared to the alternative of letting monetary policy act alone.

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