INFLATION TARGETING AND FISCAL RULES: New evidence on what makes an effective macroeconomic policy mix

01 Nov 2018

The macroeconomic policy framework – inflation targeting, fiscal rules and perhaps other institutional arrangements – should be thought of in a holistic fashion to achieve a desirable coordination between monetary and fiscal policies. Too often, however, money and public budgets are addressed separately, as if the sacrosanct independence of central banks could justify a strict conceptual dichotomy.

These are the central messages of new research by Jean-Louis CombesXavier DebrunAlexandru Minea and René Tapsoba, published in the November 2018 Economic Journal. Their results suggest, for example, that fiscal rules and inflation targeting may reinforce each other as their combined effects on inflation and fiscal balances tend to be greater than when only one of these arrangements is in place.

The concrete implication of their study is that to be successful, inflation targeting – or other policy regimes expected to deliver price stability – requires the backing of a fiscal framework that preserves fiscal sustainability and supports central bank’s efforts to stabilise the economy. Failure to do so makes countries more vulnerable to sovereign stress, high inflation or deflation.

Has inflation targeting really helped politically independent central banks to deliver price stability? Have rules aimed at capping public deficits and debts contributed to more responsible public finances?

These questions routinely surface in discussions about the adequacy of economic policies and the institutional frameworks guiding them. Too often, however, money and public budgets are addressed separately, as if the sacrosanct independence of central banks could justify a strict conceptual dichotomy.

The authors of the new study reaffirm that such a dichotomy flies in the face of both theory and evidence. They first recall that theory has long considered monetary and fiscal policies as inseparable twins joined at birth by the need to secure governments’ solvency.

Indeed, there are times when governments see printing money and deflating the real value of public debt as the only way formally to honour their obligations and avoid outright default. A decade ago, the global economic and financial crisis also brought back to the fore the shared responsibility of central bankers and politicians for stabilising economic activity by steering aggregate demand.

To get a sense of monetary-fiscal interdependencies, the study looks at how formal policy frameworks have jointly affected two key macroeconomic outcomes: inflation and the fiscal balance.

Modern policy frameworks, which consist of explicit objectives, procedures and constraints to guide policy decisions, often take the form of inflation targeting and fiscal rules. These institutional similarities across countries make it possible to conduct an empirical analysis over a large panel of advanced and developing economies during the period from 1990 to 2009.

A first empirical question is whether inflation targeting can influence fiscal policy, and whether fiscal rules can affect monetary policy. In other words, are there ‘cross-effects’ related to the adoption of policy frameworks? A second important question is whether inflation targeting and fiscal rules complement each other in terms of their influence on outcomes.

The results indicate significant and sizable cross-effects: the adoption of inflation targeting or fiscal rules alone is associated with stronger fiscal performance (higher fiscal balances all else equal) and lower average inflation. There is also suggestive evidence that fiscal rules and inflation targeting may reinforce each other as their combined effects on inflation and fiscal balances tend to be greater than when only one of these arrangements is in place.

These results are robust to relevant alterations of the baseline analysis. In particular, the strength of a fiscal rule – in terms of its ability to tie policy-makers’ hands – seems relevant: stronger-than-average fiscal rules appear to have a greater impact on policy outcomes – directly on fiscal policy and through inflation targeting interactions on inflation. There is also some evidence that shifts from unconstrained fiscal policies to even weak fiscal rules could signal a sufficiently meaningful regime shift that will affect fiscal balances and inflation favourably.

These results clearly reject the monetary-fiscal dichotomy suggested by a superficial interpretation of central bank independence. They indicate that macroeconomic frameworks (inflation targeting, fiscal rules and arguably other institutional arrangements) should be conceived in a holistic fashion to achieve a desirable coordination between monetary and fiscal policies.

Concretely, this means that to be successful, inflation targeting – or other policy regimes expected to deliver price stability – requires the backing of a fiscal framework that preserves fiscal sustainability and supports central bank’s efforts to stabilise the economy. Failure to do so makes countries more vulnerable to sovereign stress and undesirable trends in prices (high inflation or deflation).

Inflation Targeting, Fiscal Rules and the Policy Mix: Cross-Effects and Interactions’ by Jean-Louis Combes, Xavier Debrun, Alexandru Minea and René Tapsoba is published in the November 2018 issue of the Economic Journal.