Does inflation targeting need help from fiscal policy?
The case against stronger monetary-fiscal coordination
US Federal Reserve Chair Powell and Treasury Secretary Yellen. Photo credit: US Federal Reserve and Reuters.
We will soon get a new Statement on the Conduct of Monetary Policy between the Treasurer and the RBA Board (previous iterations were between the Treasurer and Governor). It will be only the eighth such Statement since the first one in August 1996.
New statements typically accompany either a change in Governor or change in government. The extant 2016 Statement has been unusually long-lived. The Morrison government re-elected in 2019 left the 2016 Statement unchanged, despite a Treasury push to introduce stronger accountability mechanisms through a revised Statement. When the current government assumed office in 2022, the Statement was again left unchanged pending the outcome of its RBA Review.
Now that the Review has completed its work and a new Governor has been appointed starting next month, a new Statement is the next order of business. Zac Gross has a nice discussion of the role of the Statement in defining Australia’s monetary policy framework.
One issue a new Statement will need to address is the relationship between monetary and fiscal policy. The current Statements stipulates that:
‘For its part the Government endorses the inflation objective and emphasises the role that disciplined fiscal policy must play in achieving medium-term price stability.’
Essentially identical wording has been used in every statement since 1996.
A straightforward interpretation of this clause is that the government should not blow-up the inflation target through irresponsible fiscal policy. The reference to ‘disciplined fiscal policy’ suggests a somewhat asymmetrical interpretation of the risks that fiscal policy poses to the inflation target. Too much fiscal discipline might also create a risk of undershooting the inflation target. Indeed, this claim was often made in the low inflation period pre-pandemic, although I think that claim is mistaken. It was monetary rather than fiscal policy that was too tight. Asking fiscal policy to do the RBA’s job for it would be a bizarre inversion of the more or less explicit institutional division of labour between monetary and fiscal policy in relation to demand management.
The RBA Review recommended that a revised Statement ‘should acknowledge the importance of both monetary policy and fiscal policy for macroeconomic outcomes’ and made a number specific recommendations to give effect to greater monetary and fiscal coordination, without compromising the independence of monetary policy. The Review said that the government’s fiscal strategy should acknowledge the role of fiscal policy in inflation dynamics. The Review also suggested that ‘fiscal policy may have a larger role in some circumstances, for example when the cash rate is at its effective lower bound.’ Fiscal spillovers from the bond purchase program were also raised by the Review as strengthening the case for monetary-fiscal coordination. Such coordination was part of the Review’s rational for retaining the Treasury Secretary as a member of the RBA Board. At the same time, the Review acknowledged that monetary and fiscal policy will sometimes pull in opposite directions given that fiscal policy has broader objectives than monetary policy.
Eric Leeper on monetary-fiscal interactions
The RBA Review asked Eric Leeper to consider these issues in his paper Monetary-Fiscal Policy Interactions for Central Bankers. Leeper is a leading authority on these issues. His approach is embedded in the fiscal theory of the price level (FTPL). As we have noted in these pages previously, the FTPL has significant overlap with MMT, but the Cochrane-Leeper version draws very different policy implications. Both versions proceed from the observation that government bonds and base money are government liabilities. The price level is the rate at which government liabilities exchange for goods and services. In equilibrium, the presence of the price level in the bond pricing equation that equilibrates the supply and demand of government debt necessarily imposes a relationship between monetary and fiscal policy. This is consistent with the monetarist conception of the role of the price level in relation to the supply and demand for real money balances.
The literature on monetary-fiscal interactions has long recognised that fiscal policy can dominate monetary policy in the determination of the price level. Most historical episodes of hyper-inflation have arisen through monetary accommodation of fiscal policy, in particular, central bank financing of government spending. Indeed, prior to 1982, Australia’s budget deficits were partly financed by borrowing from the central bank and this contributed to high rates of inflation. This is the reason most advanced economies have institutional separation of monetary and fiscal policy and governments are usually required to borrow from the public rather than the central bank.
Leeper argues that fiscal policy has been largely banished from New Keynesian models or enters them in trivial ways. Ricardian offset is often invoked to conveniently suppress wealth effects from fiscal policy. A bigger issue in an Australian context for fiscal policy is open economy crowding out-effects via the exchange rate and net exports, which Leeper does not mention at all. With notable exceptions like Prassana Gai, a problem with some of the papers commissioned by the Review is a lack of more detailed engagement with Australia’s particular circumstances. Leeper does examine the role played by fiscal policy in the RBA’s main models, noting in the case of the RBA’s MCM model that ‘if the model’s predictions for tax revenues were included in assessments of model fit, the data would choke on those predictions.’
Leeper attributes the suppression of fiscal policy in New Keynesian models to their formalisation of monetarist insights, with interest rates replacing monetary aggregates as the monetary policy operating instrument. Leland Yeager long ago made essentially the same point about the debt New Keynesian models owe to monetarism, but it is a very narrow lift from the monetarist tradition. Leeper briefly references Brunner and Meltzer’s 1972 JPE paper, among many others, which recognised scope for monetary and fiscal interactions. He could have also referenced Brunner and Meltzer’s insight that money and bonds are imperfect substitutes and that this has major implications for the FTPL. ‘Transactions services for currency’ are briefly mentioned as part of the payoff to money as an asset, but not further discussed. Leeper is nonetheless right to argue that there is too much focus on the short-run hydraulics of fiscal policy at the expense of long-run debt dynamics.
In Leeper’s view, inflation is jointly determined by monetary and fiscal policy. That is almost certainly true, but he draws overly strong implications for the need for monetary and fiscal coordination. His strongest claim, following Cochrane, is an observational equivalence result that ‘any economic outcomes that a monetary dominant regime produces can be replicated by a fiscal dominant regime.’ That result might hold in theory, but it is not our lived experience of regimes characterised by fiscal dominance. The result only holds if we sweep away the very different institutional arrangements in which monetary and fiscal policy are typically embedded and which are designed to preclude fiscal dominance (whether they succeed in doing that is perhaps Leeper’s real concern). The uncertainty about the optimal stance of monetary policy is only multiplied once we allow for monetary-fiscal interactions. Things get even more complicated if we introduce game-theoretic interactions between the monetary and fiscal authority.
Leeper maintains that central bankers are not sufficiently mindful of monetary-fiscal interactions and overweight monetary policy in the determination of inflation and his paper is directly addressed to them. That is probably true of central bank modelling, but it is hardly consistent with our experience of macroeconomic policy in recent decades. If anything, too much weight has been given to fiscal relative to monetary policy by policymakers and this played a major role in central banks undershooting their inflation targets in the pre-pandemic era. The Great Economic Experiment of 2013 showed that monetary policy could sustain a US expansion against the backdrop of the biggest fiscal consolidation since World War Two, despite predictions to the contrary.
Australia’s macro policy response to the pandemic is another case in point. Monetary policy went MIA between March and November 2020 as policymakers explicitly placed a higher burden on fiscal policy, inducing open economy crowding out effects that ultimately required an even more aggressive bond purchase program.
Leeper argues that fiscal rules may not provide the necessary fiscal backing to allow monetary policy to successfully target inflation. He maintains that ‘policy conflicts emerge from an enduring partial equilibrium belief that monetary and fiscal policy can operate independently of each other, pursuing objectives that in general equilibrium may be mutually exclusive…Economic theory tell us that in the long run monetary and fiscal policies must be coordinated in the sense that they are consistent with equilibrium.’ In long-run equilibrium that might be true, but monetary policy is preoccupied with the short-run, while debt dynamics are more of a long-run issue. It may well be that long-run debt dynamics eventually blow-up inflation targeting regimes, but that is not a short-run monetary-fiscal coordination problem, it is a much deeper political economy problem involving the government’s long-run budget constraint.
Leeper’s practical examples, at least in relation to the US, are not convincing. The US pandemic response is pinged on the basis that the Fed’s actions generated negative spillovers for US fiscal policy. Leeper is correct to argue that ‘important Federal Reserve actions were taken without fiscal authority buy-in’ and that ‘by “taking duration out of private hands” Fed actions have converted what would have been private losses into public losses.’ But that is a feature, not a bug. Leeper says this ‘is a politically fraught act that may haunt Fed officials in coming years.’ That might be true, but the most likely counterfactual of greater monetary-fiscal coordination is that Congress would have opposed the Fed’s pandemic response, without offsetting fiscal policy action. In the event, the fiscal policy response we did see was difficult to mobilise relative to Fed’s response. This goes to my broader criticism of analyses grounded in the FTPL that they are at best selective about, if not blind to, these institutional realities. We have enough difficulty getting the US Congress and the executive on the same page in terms of fiscal policy. Throwing the Fed into the mix is a problem best left for game theorists. I suspect Lars Svensson would also take issue with Leeper’s interpretation of Sweden’s macro policy mix in the 2010s.
Leeper calls for more explicit rather than implicit coordination and greater transparency about the relationship between monetary and fiscal policy, as well as better modelling of fiscal policy, but it is not clear to me that this will lead to better macro outcomes. Policy coordination is difficult and institutional frictions may lead to sub-optimal policy relative to implicit coordination/accomodation or even uncoordinated policy. Again, Australia’s pandemic experience is instructive, in which whatever coordination took place arguably led to institutional shirking by the RBA. Overly tight pre-pandemic monetary policy led to calls for more activist fiscal policy, not because monetary policy needed the help, but because monetary policy was not really trying. This was monetary policy dominance, but the sub-optimal macro outcomes were not due to a coordination failure in relation to fiscal policy. Treasury’s push for greater accountability mechanisms in a revised Statement on the Conduct of Monetary Policy in 2019 was an attempt to control the RBA’s shirking and deflection, but that’s solving for an incentive problem more than a coordination problem.
As noted in my previous discussions of MMT, there is no doubt that under the right conditions, fiscal policy can dominate monetary policy. Existing macro frameworks are designed to prevent fiscal dominance, but Leeper’s argument that this has led to excessive reliance on monetary policy is hard to square with the rhetoric and actions of US or Australian policymakers in recent decades. As market monetarists have argued in the case of both countries, monetary policy has if anything been neglected and the role of fiscal policy exaggerated.
The new Statement on the Conduct of Monetary Policy should certainly mandate fiscal and monetary cooperation with a view to ensuring that both arms of policy are mutually informed and that their respective contributions to macroeconomic outcomes are transparent and well understood. The RBA’s Review’s recommendations in relation to monetary and fiscal cooperation, informed partly by Leeper’s paper, should be implemented. But the more important task for the Statement is to ensure that monetary policy pulls its own weight in targeting inflation. That will minimise the macro stabilisation burden on fiscal policy and if anything reduce the need for more formal or explicit coordination between monetary and fiscal policy.
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