Central banks will not be able to tame inflation without better fiscal policy, says the study

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

JACKSON HOLE, Wyo., Aug 27 (Reuters) – Central banks will fail to control inflation and may even push inflation higher unless governments start playing their part with more prudent budget policies, according to a study presented to policymakers at Jackson Hole conference in the United States.

Governments around the world opened their coffers during the COVID-19 pandemic to support economies, but these efforts have helped push inflation to the highest levels in nearly half a century, raising the risk that rapid price increases will become entrenched.

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

“If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the worsening of fiscal imbalances will lead to even higher inflationary pressures,” said Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed.

“As a result, a vicious circle would arise with rising nominal interest rates, increasing inflation, economic stagnation and increasing debt,” the paper claimed. “In this pathological situation, monetary tightening will actually stimulate higher inflation and trigger harmful fiscal stagflation.”

On track this fiscal year to come in at just over $1 trillion, the U.S. budget deficit is set to be far smaller than previously estimated, but at 3.9% of GDP, it remains historically high and will decline only marginally next year.

The eurozone, which also struggles with high inflation, is likely to follow a similar path, with the deficit at 3.8% this year and remaining high for years, especially as the bloc is likely to suffer a recession starting in the fourth quarter.

The study claimed that about half of the recent rise in US inflation was due to fiscal policy and an erosion of belief that the government would conduct prudent fiscal policy.

While some central banks have been criticized for recognizing the inflation problem too late, the study argued that even earlier rate hikes would have been futile.

“More hawkish (Fed) policy would have lowered inflation by only 1 percentage point at the cost of reducing output by about 3.4 percentage points,” the authors said. “This is a pretty big victim relationship.”

To control inflation, fiscal policy must work together with monetary policy and reassure people that instead of inflating the debt, the government will raise taxes or cut spending.

Reporting by Balazs Koranyi; Editing by Paul Simao

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