The most important speech at Jackson Hole last week was given by Janet Yellen but the most interesting by Christopher Sims, a Princeton economics professor. His topic was dry – fiscal policy, monetary policy and central bank independence – but he made it searingly relevant to the global economy’s current woes. Here is a summary.
Are central banks truly independent? In theory, yes but in practice, not really. The idea is that central banks should be insulated from short-run political forces and charged with controlling inflation. However, some fiscal policy moves can force the hand of central banks and every monetary policy action has fiscal consequences.
A good example is Brazil in the 1980s where increases in official rates to reduce inflation actually had the opposite effect. The reason was that interest payments were a large part of public finances. Thus, when the central bank raised rates, it also increased the budget deficit and boosted demand. Monetary tightening caused fiscal loosening and was thus self-defeating. Hence, central bank independence depends upon interest payments being a small part of public spending.
Do large central bank balance sheets matter? Yes, they do because quantitative easing has created a risk mismatch between assets and liabilities. The liabilities (e.g. currency, bank reserves) are short duration but the assets (e.g. government bonds) are long duration, thus putting the central bank in danger of technical insolvency if it raises interest rates. Of course, a central bank should never go bust because it can “print money” to cover losses but the loss of confidence and the financial dislocation could be badly damaging.
Why has monetary policy failed to create 2% inflation? Partly because it is tough for central banks to push interest rates much below zero but also because, at low inflation rates, effective monetary policy requires fiscal expansion to accompany interest rate cuts.
It is understandable that politicians worry about high budget deficits and debt-to-GDP ratios and that electorates suspect that today’s budget deficit is tomorrow’s tax increase. However, in Europe and Japan, tight fiscal policy has offset easy monetary policy and condemned their economies to prolonged low growth, low inflation. In the US, there has been less emphasis on budget cuts and the US economy has performed a little better.
Is fiscal deficit finance a better idea? Possibly but it requires deficits specifically aimed at generating inflation. The deficits must be seen as financed by future inflation, not future tax hikes or spending cuts.
With government bond yields at record lows and a pressing need for more roads, railways, bridges and so on, the idea of “infrastructure bonds” to pay for these projects is attractive. However, this will only work if the authorities make clear that part of the purpose is to raise inflation and that it will not cut back on existing spending to “pay” for the infrastructure.
Implications. Christopher Sims’ thoughtful speech has several important consequences. First, monetary policy and fiscal policy have to work together. At present, they don’t. Second, Japan and continental Europe will continue to experience low growth and inflation, which in turn suggests zero or negative short rates for some time. Third, Sims’ analysis justifies gradual and limited interest rate increases in the US. Fourth, easy monetary policy will support global equity markets but do little to boost them further. Much the same applies to government bond markets.
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