Lessons from the Inflation Shock

For a long time, it seemed clear that in the event of inflation, monetary authorities would have to fight it with high interest rates. Governments were not involved. Now a number of governments have responded to the inflation shock of 2022 with price brakes and other interventions – and apparently successfully. Is it time to rewrite the textbooks?

Co-author Jérôme Creel from the Paris-based OFCE discussed the results of a new Forum New Economy Working Paper with Peter Bofinger – in our New Economy Short Cut: “Lessons from the inflation shock: A new paradigm for central banks and governments?”.

The paper by the OFCE economist and colleagues discusses the traditional “separation paradigm” in economic policy, which separates fiscal and monetary policies’ roles, with governments focused on debt sustainability and central banks on inflation. However, recent events, such as the Global Financial Crisis and inflation resurgence, have challenged this paradigm. Governments have increasingly intervened in economic policy, notably through fiscal measures. The author explained how various crises, including COVID-19 and energy price increases, have prompted innovative fiscal policies. He argues that the separation paradigm limits flexibility and hinders effective policy responses, and advocates for a new paradigm that integrates fiscal and monetary policies to address multiple objectives, including climate change and economic stabilization.

Four main ideas are proposed for a new paradigm that promises a more balanced and effective approach:

• The first principle cautions against overestimating the efficacy of monetary policy. Empirical evidence has highlighted its limitations, notably its sometimes sluggish and inadequate responses to economic challenges. Given that inflation can stem from a multitude of sources, it becomes clear that monetary policy should not be the sole tool for economic stabilization.
• The second tenet emphasizes the importance of not underestimating fiscal policy. Recent developments, such as supply-driven fiscal initiatives like the Inflation Reduction Act (IRA), illustrate the potential of fiscal measures to directly impact the economy.
• The third idea advocates for a renewal of the policy mix and enhanced coordination between monetary and fiscal policies. This calls for a strategic integration of both policies, where the strengths of one compensate for the weaknesses of the other.
• The fourth concept introduces a reimagined approach to “sound” fiscal policy, moving away from the traditional ‘three T’ approach towards TILT policies, i.e. Timely, Investment-related, Lasting (to match the entire horizon of the ecological transition) and Targeted (towards intertemporal fairness).

Würzburg University Professor, Peter Bofinger, – who has recently published a paper on this matter – endorses these arguments and, similarly, advocates for a reevaluation of economic stabilization policies, contrasting the historical reliance on monetary policy with the “functional finance” perspective that views fiscal policy as equally important for managing both inflation and unemployment. He argues that there is no theoretical basis for the primacy of monetary policy in controlling inflation, suggesting that unconventional fiscal strategies, like adjusting indirect taxes, can be effective without harming output. Ultimately, he adds, this choice between monetary and fiscal policy hinges on several criteria: the type of economic shock (demand or supply), the magnitude of the shock, whether the country is part of a currency union, and the government’s time horizon.

Monetary policy offers the advantage of quick decision-making, which is critical during economic downturns. This rapid response capability is attributed to the relatively short inside lag, the time it takes for a policy decision to be made and implemented. However, monetary policy is not without its drawbacks. The primary challenge lies in the long outside lag, which refers to the delay between the implementation of a policy and its impact on the real economy through the various transmission channels. Additionally, monetary policy can have unintended side effects that may complicate economic conditions further.

In scenarios where the government is the source of demand shocks, such as significant discretionary expenditures like those seen in the U.S., monetary policy is clearly preferable. This is because central banks can quickly adjust policy tools to counteract these shocks. Conversely, fiscal policy is preferable in the case of supply shocks, as it can navigate the trade-offs associated with monetary policy interventions. However, a critical drawback of fiscal policy is its long inside lags, primarily due to the time-consuming process of parliamentary approval. Yet, recent events, such as rapid fiscal responses during energy crises, suggest that fiscal policy can be implemented more promptly than in the past. This speed, however, has raised concerns about a democratic deficit, highlighting the need for more democratic, long-term fiscal policy decisions.

A notable example within the European Monetary Union (EMU) highlights the limitations of a strict separation between monetary and fiscal policy responsibilities. The EMU’s framework, which primarily assigns the responsibility of price stability to the ECB, overlooks the necessity for national responses to idiosyncratic shocks. For instance, an argument could be made that Germany might have had more incentive to combat deflation during the 2014-16 period with expansionary fiscal policy if it had a national price stability mandate.

On a positive note, both economists acknowledge that the inflation crisis has significantly shifted the public policy debate, with new perspectives emerging on fiscal stances.