How Fiscal Restraint Can Help Fight Inflation

IMF Blog, November 21, 2022

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Authors: Tobias Adrian, Vitor Gaspar
Date: November 21, 2022
Core message: Fiscal policy can ease the task of monetary policy in reducing inflation while mitigating risks to financial stability.

Government support was vital to help people and firms survive pandemic lockdowns and support the economic recovery.
Most governments have already dialed back pandemic support, as noted in our October Fiscal Monitor.
With many people still struggling, governments should:
- prioritize helping the most vulnerable to cope with soaring food and energy bills and cover other costs; and
- avoid adding to aggregate demand that risks dialing up inflation.
In many advanced and emerging economies, fiscal restraint can lower inflation while reducing debt.

Central banks are raising interest rates to dampen demand and contain inflation, which in many countries is at its highest levels since the 1980s.
A smaller deficit cools aggregate demand and inflation, so the central bank doesn’t need to raise rates as much.
Reducing deficits addresses debt vulnerabilities given that global financial conditions are constraining budgets and public debt ratios are above pre-pandemic levels.
Fiscal stimulus in the current high inflation environment would force central banks to "slam on the brakes" harder to curb inflation, which amid elevated public and private sector debt may raise risks for the financial system (as noted in the October Global Financial Stability Report).

Policymakers should provide strong protections to those in need while paring back elsewhere or raising additional revenues to reduce the overall deficit.
Fiscal responsibility—or even consolidation where needed—demonstrates that policymakers are aligned against inflation.
When fiscal adjustment is sustained, ideally through a medium-term fiscal framework that sketches the direction of policy over the next few years, it also addresses looming pressures on debt sustainability, including:
- aging populations in most advanced and several emerging economies; and
- the need to rebuild buffers that can be deployed in future crises or economic downturns.

Research approach: stylized two country model (where the “home economy” may be the US or a group of advanced economies).
Two approaches to curb inflation are studied:
- Exclusive reliance on monetary tightening.
- Fiscal consolidation.
Both approaches are constructed to have similar effects on economic growth, and each is effective in reducing inflation.
Under exclusive monetary tightening:
- higher interest rates and weaker growth contribute to rising public debt;
- the currency appreciates as higher yields attract investors.
Under fiscal tightening:
- demand is cooled without the need for interest rates to rise, so the real exchange rate depreciates;
- with lower debt-service costs and smaller primary deficits, public debt declines.
The real exchange-rate appreciation under tighter monetary policy implies that inflation falls a bit more, but this difference would diminish if more countries pursued fiscal restraint.

Faced with high food and energy prices, governments can improve their fiscal position by moving from broad-based support to assisting the most vulnerable—ideally, through targeted cash transfers.
Because supply shocks are long-lasting, attempts to limit price increases through price controls, subsidies, or tax cuts will be costly to the budget and ultimately not be effective.
Price signals are critical to promote energy conservation and encourage private investment in renewables.

The desirable fiscal stance and measures depend on country-specific circumstances, including:
- current inflation rates;
- longer-term considerations such as debt levels and developmental needs.
In most countries, higher inflation strengthens the case for fiscal restraint, calling for raising revenue or prioritizing spending that preserves social protection and growth-enhancing investments in human or physical capital.

The early-1980s disinflation under Federal Reserve Chairman Paul Volcker illustrates the challenges of controlling entrenched inflation when fiscal policy is expansionary:
- The Fed had to raise rates sharply, causing a collapse in housing investment and historically large appreciation of the dollar.
- Manufacturing was hard hit, leading to calls for trade protectionism.
A more balanced removal of policy stimulus, including fiscal restraint, can reduce the risk that parts of the economy most sensitive to interest rates experience disproportionate effects, or that large swings in the currency heighten trade tensions.
Globally, fiscal restraint would:
- imply less abrupt interest rate hikes and a more gradual tightening of financial conditions;
- mitigate financial stability risks and limit adverse spillovers to emerging market economies;
- reduce the risk of sovereign debt distress;
- lessen pressures on emerging markets that borrow in major currencies by avoiding a sharp appreciation of the US dollar or other major currencies.

While many central banks are tightening policy in response to the large and persistent rise in global inflation, fiscal restraint will reduce the cost of bringing inflation back to target in a timely way compared with leaving monetary policy alone to act.

How Fiscal Restraint Can Help Fight Inflation — IMF blog page, November 21, 2022