Don’t Mention The Fiscal Stagflation Paper

A fixture of the pandemic-era, wartime inflation debate is the (largely self-evident) contention that central banks can’t solve supply shocks. Only offset them by engineering demand destruction.

Initially, that was dismissed as a somewhat trivial concern. After all, most supply factor-driven inflation would resolve on its own. It was “transitory.”

Even if supply frictions were inclined to “fix themselves” (and it’s not obvious they were), Vladimir Putin’s decision to invade Ukraine and Xi Jinping’s refusal to accept COVID as an endemic condition, ruled out a return to normal. In the meantime, inflation broadened out, helped along by fiscal and monetary stimulus, which together juiced demand in a supply-constrained environment. By the time central banks realized what was happening, it was too late.

There’s a way out, we’re told. But it’ll be painful. It’s the Volcker medicine, which central bank chiefs the world over are begrudgingly obliged to administer, even if not all of them have fully acquiesced to their fate.

The underlying assumption is that central banks can always pull the emergency brake. They can always destroy demand. But there’s a problem: Rate hikes may not matter if fiscal policy is perceived as too lax. In fact, they (rate hikes) may even make the situation worse.

That’s according to research by Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed whose paper, “Inflation as a Fiscal Limit,” was presented at Jackson Hole.

What piqued my interest initially was Matthew Boesler’s headline for Bloomberg: “Fed Can’t Fix Fiscal-Driven Inflation.” That had potential. For a cheap punchline, I mean. Something like this: If central banks can’t fix cost-push shocks and their capacity to curb inflation by destroying demand is limited by shifting perceptions of fiscal policy, what exactly is the point?

But, upon perusing the paper, I was struck by how eminently readable the first half-dozen pages are. Working papers and peer-reviewed journal articles aren’t famous for being page-turners. Generally speaking, no one reads them. In some cases, that can be taken almost literally. Academics often spend years attempting to get “published,” where “published” means having a peer-reviewed article accepted, only for the work to languish in near total obscurity for all eternity.

To be clear, literary flare won’t change any of that. That’s just the way the system is set up. It wouldn’t matter if Stephen King wrote the abstract, the introduction and the conclusion, readership for a given paper will invariably be nonexistent. As such, academics can hardly be blamed for what often comes across as a single-minded pursuit of mathematical and scientific rigor with little, if any, attention paid to compelling prose.

In that context, it’s somewhat remarkable that Bianchi and Melosi appeared to devote a considerable amount of time and effort to ensuring that anyone who endeavored to read the paper actually enjoyed it.

As regular readers can attest, I’m not a fan of “fiscal limit” analysis, or at least not in the context of developed markets and certainly not in the context of the US. However, Bianchi and Melosi outlined what they (aptly) described as an “interesting limit” on fiscal policy. It comes down, in part anyway, to perceptions. And when it comes to inflation, I’m a proponent of the notion that perception matters perhaps more than anything else.

However, I’m skeptical of the notion that average citizens understand enough about economic theory to adjust their expectations based solely on the perception that a given fiscal policy regime lacks credibility or is otherwise unsustainable. Certainly, people know prices are rising for goods and services. But I (still) find the notion that the public is savvy enough (or cares enough) to attribute the situation to a fiscal credibility deficit (or any other deficit) somewhat implausible.

There are two caveats. First, political propaganda can make the public more aware than they otherwise might be. Stickers of Joe Biden with the caption “I did this” designed to be placed next to the digital readout on gas pumps, are one example. Second, I’ve long argued that the biggest risk associated with Modern Monetary Theory’s meteoric rise was the extent to which making the public aware of how government finance actually works risks un-anchoring inflation expectations. The public’s “Aha! It does grow on trees!” moment might be the beginning of the end. In that case, Stephanie Kelton would go down as one of the most tragic heroes in world history.

Bianchi and Melosi alluded to the possibility that public awareness of fiscal latitude in the wake of the pandemic helped loose the genie. “Going forward, a clearer demarcation of the boundaries of fiscal policy might be needed to ensure low and stable inflation,” they wrote. In other words: Now that the public is aware of how things actually work, it might be necessary to emphasize that although there are no limits in theory (as we saw with the initial pandemic rescue package) there are limits in practice.

One final (important) word: None of the above should be construed as an endorsement of Bianchi or Melosi. I imagine they’re “good people” (however you want to define that), but in today’s divisive climate, and in a world where everyone has a public social media history just waiting to be parsed for the “wrong” soundbite, it’s never a good idea to unequivocally “endorse” or otherwise “vouch” for someone you don’t know personally. In a Tuesday tweet, Bianchi thanked Fox Business for the opportunity to discuss his paper on the network’s “Making Money” program, hosted by Charles Payne. Amusingly, Payne used a screenshot of Boesler’s Bloomberg article to introduce Bianchi. Assuming he noticed, I doubt Boesler was excited about being co-opted in Fox’s efforts to co-opt Bianchi’s research.

Without further ado, I wanted to highlight a few selected passages from “Inflation as a Fiscal Limit.” The full paper is more than three-dozen pages long, and I do encourage anyone interested to read it in full, although as with all academic papers, you can generally skip the sections which detail the math.

Trend inflation is fully controlled by the monetary authority only when public debt can be successfully stabilized by credible future fiscal plans. When the fiscal authority is not perceived as fully responsible for covering the existing fiscal imbalances, the private sector expects that inflation will rise to ensure sustainability of national debt. As a result, a large fiscal imbalance combined with a weakening fiscal credibility may lead trend inflation to drift away from the long-run target chosen by the monetary authority. This reasoning configures a natural and interesting limit on fiscal policy. This limit takes the form of incompatibility between lax fiscal policy and a monetary framework aimed at achieving a low and stable inflation environment. When fiscal imbalances are large and fiscal credibility wanes, it may become increasingly harder for the monetary authority to stabilize inflation around its desired target. If the monetary authority increases rates in response to high inflation, the economy enters a recession, which increases the debt-to-GDP ratio. If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the deterioration of fiscal imbalances leads to even higher inflationary pressure. As a result, a vicious circle of rising nominal interest rates, rising inflation, economic stagnation and increasing debt would arise.

In this pathological situation, monetary tightening would actually spur higher inflation and would spark a pernicious fiscal stagflation, with the inflation rate drifting away from the monetary authority’s target and with GDP growth slowing down considerably. While in the short run, monetary tightening might succeed in partially reducing the business cycle component of inflation, the trend component of inflation would move in the opposite direction as a result of the higher fiscal burden. Fiscal stagflation does not stem from a perceived or actual loss of anti-inflation reputation by the central bank. Rather, it is caused by the progressive deterioration of the fiscal authority’s credibility to stabilize its large debt and the realization that the reputation of the monetary authority is incompatible with the expected behavior of the fiscal authority.

Fiscal inflation has not completely vanished after the 1980s disinflation, as agents take into account that a return to the Fiscally-led policy mix is still possible and fiscal spending remains elevated. However, the amount of fiscal inflation has remained modest for a long time because of the prevailing Monetary-led policy mix. This moderate level of fiscal inflation has counteracted exogenous deflationary pressure and it has helped the central bank to avoid deflation. In fact, absent fiscal inflation, the US economy would have experienced a larger deflationary bias and larger output losses during the years spent at the zero lower bound. Thus, historical circumstances might have provided a false sense of irrelevance of fiscal sustainability considerations.

The COVID pandemic, with a second spell of zero lower bound after only a few years of slightly positive interest rates, has arguably changed this perception. [F]ollowing the American Rescue Plan Act fiscal stimulus, the probability assigned to moving to the Fiscally-led policy mix experienced a large increase. This change in beliefs has resulted in a large jump in fiscal inflation, accounting for approximately half (3.5%) of the recent increase in inflation, with cost-push shocks contributing by a similar amount. However, cost-push shocks and fiscal imbalances affect inflation in very different ways. Cost-push shocks have only transitory effects on inflation, independently from the policy mix in place. Instead, shocks to long-term spending propagate very differently across monetary and fiscal policy regimes and remain a potential threat to inflation stability for a long time, given that they affect the fiscal burden for many years.

The recipe used to defeat the Great Inflation in the early 1980s might not be effective today. In the early 1980s, the resolute anti-inflation stance taken by the Federal Reserve and backed by the new administration was the winning move. An important factor behind this success was the historically low government debt that provided strong credibility to the fiscal backing. Today the problem of controlling inflation is compounded by the highly uncertain fiscal situation, with the Congressional Budget Office projecting federal debt to keep rising after the year 2023 to reach its highest level ever recorded in 2032. Therefore, even though monetary policy independence is a much more widely respected and better understood value today, high inflation can still be a threat if the fiscal situation is left unresolved. In fact, we show that if the private sector loses confidence in the fiscal authority’s willingness to fix this quickly-deteriorating fiscal backdrop, hawkish monetary policies can mire the US economy in a prolonged period of stagflation. All told, our results suggest that conquering the post-pandemic inflation necessitates an overhaul of the fiscal framework aimed at financing the large stock of government debt as well as the increase in public expenditure needed to cover rising costs associated with population aging and climate change.

If the monetary authority had anticipated the liftoff and tightened the interest rate aggressively, it would not have been able to suppress the large increase in inflation. This is because half of the increase in inflation observed in 2021 has a fiscal nature and it is driven by a shift in beliefs about how the large stock of debt and the ARPA stimulus will be financed. The more hawkish monetary policy would have lowered inflation by only 1 percentage point at the cost of reducing output by around 3.4 percentage points. This is a quite large sacrifice ratio. This result is not driven by the presence of cost-push shocks. When we completely remove cost-push shocks, output barely changes while inflation remains elevated at around 4.6%. This result is driven by agents’ beliefs. In this counterfactual scenario, we keep the fiscal shocks and agents’ beliefs unchanged. The central bank is increasing the policy rate, but agents still expect that the ARPA stimulus has increased the probability of moving to the Fiscally-led policy mix. By increasing interest rates, the Federal Reserve is able to cool down the economy because of nominal rigidities. However, the assumed monetary tightening alone is not enough to significantly cut inflation because price dynamics are mostly driven by a perceived lack of fiscal sustainability. [A]nticipating the liftoff and swiftly raising the policy rate in isolation would not have averted the post-pandemic surge in prices.

The increase in spending determines inflationary pressure because agents expect that eventually the additional fiscal burden will be stabilized with inflation. As the central bank increases the response to inflation, the initial jump in inflation becomes smaller at the cost of generating a larger contraction in real activity. [T]he success on inflation is ephemeral. Eventually the paths of inflation cross and the more hawkish response leads to higher inflation and larger output losses. The reason is as follows: The more hawkish the monetary policy response, the larger the increase in the fiscal burden, the larger the acceleration in inflation. Across all scenarios, fiscal stagflation persists as agents expect that the increase in the fiscal burden will also contribute to generating future inflation. This result is driven by the fact that while the response of the monetary authority to fiscal inflation becomes progressively more hawkish, agents’ beliefs about future policy remain unchanged. The reason behind this apparently puzzling result is that by tightening monetary policy, the monetary authority increases the service of the debt and depresses output. As a result, the debt-to-GDP ratio increases. Agents expect that the debt will not be stabilized by future fiscal adjustments, which leads to an increase in fiscal inflation. The monetary authority raises the interest rate even more to respond to the rising fiscal inflation, exacerbating the fiscal imbalance and further accelerating the price dynamics.

Following the COVID pandemic, the United States, like many other countries, has implemented robust fiscal interventions. We have shown that these policy interventions facilitated the quick rebound observed after the pandemic recession. At the same time, they also contributed to the surge in fiscal inflation. Increasing rates, by itself, would not have prevented the recent surge in inflation, given that large part of the increase was due to a change in the perceived policy mix. In fact, increasing rates without the appropriate fiscal backing could result in fiscal stagflation. Instead, conquering the post-pandemic inflation requires mutually consistent monetary and fiscal policies providing a clear path for both the desired inflation rate and debt sustainability.