Can inflation be a fiscal phenomenon?
- Sarah Baek
- Feb 23, 2022
- 4 min read
Updated: Mar 12, 2022
For the past decade, many rich economies have had their interest rates remaining essentially at the effective zero bound — the Federal Funds Rate remained as 0.25 percent as it refused to go below zero, the Bank of England (BoE)’s base rate reached 0.1 percent, and the European Central Bank (ECB) even implemented negative rates at -0.5 percent in order to stimulate the economy and avoid deflation, the so-called ‘black-hole.’ Yet even these interest rates were not enough, forcing the central banks to adopt Quantitative Easing (QE) to an astronomically high level to buoy the economy. The Fed, ECB, BoE, and Bank of Japan had altogether injected $9 trillion by buying assets.
During this time, governments mostly ran a fiscal austerity. Then a novel fiscal stimulus worth $10.8 trillion, equivalent to 10 percent of world GDP, was implemented worldwide during COVID-19. This policy resulted in high inflation, closing the deflationary gap and achieving what the monetary policy could not achieve for a decade. The rich economies saw the highest jumps in inflation: by January, the US inflation rate reached 7.5 percent, the highest peak since February 1982; inflation in the euro area rose to 5.1 percent; and the UK recorded 5.5 percent.
Nobel Laureate Milton Friedman had stated, “inflation is always and everywhere a monetary phenomenon.” Furthermore, central banks, not governments, are responsible for maintaining price stability. However, the debate surrounding the effectiveness of QE and expansionary monetary policy in the past decade has raised the question of whether inflation can also be a fiscal phenomenon.
According to a conjecture by Rother (2004), one mechanism we notice is discretionary fiscal policy’s capacity to influence aggregate demand and thus output and/or the price level too. It was also suggested that even if long-run monetary policies may “offset the short term inflationary impact of discretionary fiscal policies," this impact may "well manifest itself in short-run fluctuations of the price level, in other words, inflation volatility.” His arguments were supported by Fatas and Mihov (2003) who found that discretionary fiscal policies have contributed significantly to output volatility for 15 OECD countries, thus showing a significant positive correlation with inflation volatility. In addition, Perotti (2002) had shown similar results in the EU.
The reason behind the occurrence can be explained by the fiscal theory of the price level. The theory considers price level as a crucial adjustment variable when a government aims to meet its intertemporal budget constraint. The constraint here equates the government’s current liabilities to the net present value of government revenues. For example, when the Ricardian Equivalence does not hold and assumes that the central bank is strongly committed and independent, the imbalances in the intertemporal budget constraint are adjusted with the price level. This adjustment is driven by wealth effects — “individuals perceive budget deficits as increases in wealth which induce them to raise spending thus driving up the price level,” according to Rother (2004). However, with Ricardian Equivalence, wealth effects of deficits would be neutral as consumers are forward-looking and internalise the government’s budget constraint when making their consumption decisions, “leaving the central bank in control.”
Another mechanism that suggests a fiscal phenomenon of inflation is how fiscal stimulus can strengthen households’ and firms’ balance sheets. A household balance sheet will consist of assets such as real estate, stocks, bonds and retirement funds, and liabilities such as home mortgage debt, education loans and consumer debt. A strengthened balance sheet simply means there are more assets than liabilities. Resultantly, a greater purchasing confidence inclines them to spend and effectively stimulates consumption and investments in the economy. Considering these, a government collects cash from investors giving bonds in exchange. Then the government returns the money raised to circulation by distributing it to households. The net result is that the government gave out new bonds.
However, one aspect to recognise is that in theory, a fiscal stimulus involving bonds which are essentially debt securities is less effective. This is because when a government runs its debt, the public may expect taxes to rise in the future — tax is a liability that offsets their newly created assets — thus consumption remains unchanged. Yet in practice, fiscal stimulus proved to boost consumption.
Now considering QE, the central bank creates new money by buying the government bonds. Thus the net result is bonds given out, not cash. Especially when the interest is so low that it has reached the effective lower bound, money and bonds become even closer substitutes. So many economists have pointed out that QE has simply swapped money and debt.
Some economists say that QE is only effective under extraordinary financial distress, such as the “dash for cash” in spring 2020. Now that the crisis has passed, the central banks have shrunk balance sheets and have not shown clear signs of interest rises yet. Thus it seems likely that the enormous fiscal stimulus which increases 1) household wealth and 2) the combined supply of money and debt will bring inflation.
In addition to the monetary and fiscal theories, one must consider the demand-pull and cost-push inflationary pressure. The first sign of a supply shock began with China in early 2020 where restrictions on the movement of labour and capital essentially stopped many global supply chains. Then as the world recovered in early to mid-2021, soaring demand for energy and food had driven its prices to record highs, contributing to the rise in the average consumer prices.
Once the economies recover from the temporary supply chain shocks have, economists will gain reformed insights to whether the budget deficit resulting in wealth effects, strengthened household balance sheets, and combined supply of money and debt were the causes of today’s inflation.
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