By Steven K. Beckner
At the Kansas City Fed’s Jackson Hole symposium last August,
Indiana University Professor Eric Leeper warned that a coming “extended
era of fiscal stress” will make it difficult for central banks to
control inflation unless steps are taken to curb deficit and entitlement
spending.
When the public and the markets are uncertain about the size of
future deficits and government borrowing requirements, “threats do not
arise only from insufficient resolve by central bankers to control
inflation,” Leeper wrote. “Threats arise from unanchored fiscal
expectations that can make it difficult or impossible for central banks
to control inflation, regardless of the central bankers’ resolve.”
“The central bank’s ability to control and target inflation rests
fundamentally on fiscal behavior and people’s expectations of fiscal
behavior,” Leeper warned. “When those expectations center on the
appropriate fiscal behavior, the central bank can control inflation in
the usual way, but when fiscal expectations are anchored elsewhere, it’s
quite possible that monetary policy can no longer do its job controlling
inflation and stabilizing real activity.”
In other words, governments cannot simply rely on their central
banks to keep inflation under control if they are running large
deficits. “If monetary policy is to successfully control inflation, then
fiscal policy must do much of the heavy lifting, freeing monetary policy
to pursue that objective,” Leeper said.
The late Nobel Prize winning economist Milton Friedman famously
said that inflation is always “a monetary phenomenon,” but Leeper said
that “for monetary policy to successfully control inflation, fiscal
policy must behave in a particular, circumscribed manner.”
In normal times, fiscal policy is supposed to stabilize debt,
leaving monetary policy free to target inflation. But when a government
is approaching its “fiscal limit” — the upper limit on how much tax
revenue can be raised and a lower limit on the level of government
spending — the central bank cannot respond normally.
“The more likely people believe it is that the limit will be
reached, the harder it will be for central banks to retain control of
inflation,” warned Leeper.
And responding to an inflation scare could become very tricky in an
era of “fiscal stress,” said Leeper. “Central banks might reasonably
react to the scare by preemptively tightening policy, which may slow the
economy but will do little to combat the incipient inflation, which is
driven by fiscal factors outside the central bank’s control.”
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** Market News International **
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