MNI INTERVIEW: Central Bank Autonomy Needs Fiscal Discipline

Pressures on central bank independence from heavily-indebted governments are likely to be most intense in response to supply shocks, a coauthor of a Bank of International Settlements working paper told MNI.

If public debt is already high, monetary tightening can quickly erode fiscal space even as governments could demand stimulus during a supply shock, the European University Institute's Leonardo Melosi said in an interview.

"That’s the vulnerability," he said. "If you haven’t built buffers in good times, you’re exposed when the shock hits."

The model estimates "the political headwind you face if you raise the interest rate too much," said Melosi, adding that the authors' message is that reducing this vulnerability requires countercyclical fiscal policy during expansions.

Assuming that a government cannot borrow more than 245% of GDP, the model implies political constraints on a central bank's response to a supply-driven inflationary shock 8% of the time, and that outside a shock, anticipation of the limit would raise steady-state inflation by 10 basis points. However, Melosi stressed that the quantitative estimates are very preliminary. 

"While we ultimately hope to use the model for that purpose, we are not there yet," he said in emailed responses to questions.

The fiscal limits modelled by the paper, co-authored by ECB and BIS economists, are calculated with variables including primary fiscal balance, GDP growth and inflation, Melosi said, adding that it is difficult to say in practice whether any particular central bank faces political constraints on its policy.

"The hope is that the model will provide clearer signals on this," he said.

FED, BOE

The paper highlights U.S. President Donald Trump’s pressure on the Federal Reserve to cut rates. Governments' attitudes to central bank independence evolve, making potential fiscal constraints on monetary policy even harder to evaluate in real time, Melosi noted.

However, the Bank of England’s slow tightening in response to post-COVID inflation may best be explained as an attempt not to destabilise financial markets. It has also since cut rates more slowly than if a fiscal limit were operative, he noted.

The Bank's response "makes a lot of sense, and what it signals is that there wasn’t really a fiscal-limit problem, and that political pressure on the central bank’s willingness to fight inflation was either absent or ineffective," Melosi said. (See MNI INTERVIEW: UK Debt Stabilisation Insufficient - NIESR Head)

Leaning on central banks would only work in the short term, he added, as market participants would eventually price in greater inflation risk and risk premia would rise, pushing up borrowing costs.

“As the 1960s and 1970s remind us, markets can be slow on the uptake, but they eventually wise up," he said.

ECB SYSTEM

The multi-national ECB, not beholden to any one government, may be more protected from interference, said Melosi, though he added that fiscal consolidation in countries like France will be critical in ensuring that this remains the case.

"The key issue around the fiscal limit is the extent to which governors from high-debt countries might be influenced by their own national fiscal constraints. This makes it even harder to determine the fiscal limit for the euro area," he said.

"Ultimately, whether that limit can be avoided will depend a lot on whether the new European fiscal framework proves effective in reducing the large and persistent fiscal imbalances across the euro area," he said.

"That can only be achieved with rules that effectively support countercyclical fiscal policy and foster innovation and long-run growth, moving away from the strict austerity approach of the past."

MISSING INFLATION

In the case of a recession pushing inflation lower, the limit imposed on interest rates could fall to zero or their lower bound, the paper notes.

"For a highly indebted government that is eager to rescue the economy, that increase in real rates reduces its room for manoeuvre. And once that happens, pressures on the central bank to monetise the fiscal stimulus can emerge," Melosi said. (See MNI INTERVIEW: Secular Stagnation Author Says Debt Raising R*)

Expectations of fiscal pressure on monetary policy may explain why so little deflation occurred in the wake of the Global Financial Crisis, he added.

"Maybe the reason large and persistent deflation never materialised at the zero lower bound, as our macro models would predict, is the fiscal limit itself."