Marijn Bolhuis, Jakree Koosakul, and Neil Shenai are economists at the International Monetary Fund. All views expressed are theirs, and don’t represent the opinions of the IMF, its Executive Board or management.
Central banks have embarked on the most aggressive and synchronised rate hiking cycles in decades. At the same time, fiscal deficits and debts in advanced economies continue to climb upward.
This has led many observers to note the potential tensions between monetary and fiscal policies: the combination of tight monetary policy and large deficits are damaging for fiscal sustainability, while loose fiscal policy can fuel inflationary pressures, complicating monetary policy.
To better understand fiscal-monetary tensions, we recently introduced the concept of a “fiscal R-star.” No no, please come back! We know there might be some R* fatigue, but we’ll try to explain why this variant is a helpful concept.
I have a bad feeling about this
In short, fiscal R-star is the real interest rate that stabilises a country’s debt-to-GDP ratio given its deficit path when output is growing at its potential and inflation is at target.
When fiscal R-star is above the average interest rate on government debt, there is room for fiscal policy to run larger deficits. When it falls, this room shrinks.
Fiscal R-star is similar to the R-star concept in monetary policy (and its financial R-star counterpart — the so-called “Phantom Menace”). While monetary R-star guides central banks’ interest rate policies to achieve inflation targets, fiscal R-star can guide fiscal policy to ensure debt sustainability.
By anchoring our analysis on real interest rates that affect both fiscal and monetary policies, it’s possible to analyse their relationship both theoretically and empirically.
Let’s call the difference between monetary R-star and fiscal R-star the “fiscal-monetary gap,” which measures tensions between fiscal and monetary policies.
You can derive the fiscal-monetary gap based on a standard macroeconomic setting using IS and Phillips curves and the law of motion of debt accumulation. For the math geeks, the fiscal-monetary gap is expressed as follows, where a positive gap is associated with rising debt (first term), inflation above target (second term), fiscal consolidation (third term), and a compression in term premia (fourth term).
When monetary R-star and fiscal R-star are equal, policymakers can simultaneously keep inflation at target and stabilise debt. But when monetary R-star moves above fiscal R-star, difficult policy trade-offs arise.
Based on the above equation, if the central bank sets its policy rate to match monetary R-star, public debt dynamics could become explosive without a reduction in the deficit. Alternatively, the central bank may keep rates below monetary R-star to “accommodate” deficit spending. This reduces debt accumulation but makes it harder to achieve price and financial stability.
Facing these trade-offs, policymakers may be tempted to resort to financial repression, forcing domestic savers and financial institutions to absorb government debt.
A great disturbance in the force
Our full paper documents the evolution of fiscal-monetary tensions over the course of modern history, based on 140 years of data from a group of advanced economies.
As you can probably guess, fiscal-monetary tensions peaked during the second world war. After reaching historic lows in the 1970s, the gap remained low and relatively constant from the early 1980s through the mid-2000s, primarily due to the decline in monetary R-star after the early 1980s Volcker-era disinflation.
The fiscal-monetary gap has been climbing since the mid-2000s and, as of the end of 2022, fiscal-monetary tensions are at the highest levels measured since the 1950s.
So, what happens when fiscal-monetary tensions are high?
Historically, larger fiscal-monetary gaps are followed by rising debt levels, higher inflation, and weaker exchange rates (Standard disclaimer: our empirics help identify statistically significant associations, but more work should obviously be done to tell a more thorough causal story).
Larger gaps also correlate with the so-called liquidation of government debt, which is the use of low real interest rates and surprise inflation to reduce the real value of debt. It’s therefore unsurprising that larger fiscal-monetary gaps tend to precede lower real returns on bonds and cash, with elevated risks of future debt, inflation, currency, housing, and financial crises.
These aren’t the tradeoffs you’re looking for . . .
What can we do about rising tensions between fiscal and monetary policies to avoid these adverse outcomes?
Governments have a major role to play. Assuming independent central banks can (and should!) continue to fulfil their inflation mandates, then old-fashioned deficit reduction can raise fiscal R-star and reduce fiscal-monetary tensions over time. Similarly, growth-enhancing reforms can increase potential growth and raise fiscal R-star, which would also reduce tensions.
But implementing fiscal consolidation and structural reforms can be . . . challenging. Voters aren’t keen on higher taxes and lower government spending. They’re often loath to accept near-term pains for long-term gains. Absent a fiscal crisis, it’s hard to expect governments to prioritise fiscal consolidation given significant spending needs.
Perhaps monetary R-star will resume its long decline, reducing tensions absent major fiscal policy adjustment. But as argued by Larry Summers and others, the future path of monetary R-star is highly uncertain. So, policymakers probably shouldn’t bet the house on a return of low-for-long interest rates.
Politicians might be tempted to engage in various forms of financial repression to liquidate large debt stocks, or pressure central banks to abandon their inflation targets and accommodate additional spending. But this would have disastrous consequences for savers and central bank independence.
Before choosing to live with higher fiscal-monetary tensions, policymakers would be wise to remember lessons from history and their implications for the present. Some prudence and humility in policymaking are required.
In some cases – like the early stages of the pandemic – it’s crucial that monetary and fiscal policy work in tandem to support families and companies. But when a gap opens between the real interest rate compatible with price stability and the real interest rate that stabilises the public debt ratio, something has to give. R-Star Star Wars are back.
