Policy Coordination for Fractured Times

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Unstable geopolitics complicates effective coordination of fiscal and monetary policy.
Advanced economies face a mix of high and rising public debt and persistent inflation.
The textbook remedy—central bank commitment to lower inflation backed by credible fiscal adjustment—faces new challenges from supply disturbances, trade fragmentation, and geopolitical tension.
The new global equilibrium is not yet defined; fiscal sustainability and macroeconomic stability during a rocky transition will likely require policymakers across advanced and emerging market economies to accept moderate—if temporary—higher-than-desired inflation.

Tightening by central banks raises real interest rates and slows growth, widening the primary deficit and raising the real burden of debt.
Without spending cuts or tax increases, rising interest on government bonds can increase aggregate demand and raise inflation until the real value of outstanding nominal debt aligns with expected future taxation or spending reductions.
If central banks act without a credible fiscal framework, an uncontrolled inflationary spiral can arise: aggressive tightening raises debt-service costs, intensifying inflation pressure, and prompting further tightening and worse fiscal imbalances (Bianchi and Melosi 2019).
The success of monetary contraction in reducing inflation depends on government commitment to adjusting primary surpluses—known as fiscal backing.
The effectiveness of monetary-fiscal coordination historically rests on a relatively stable geopolitical environment and a widely accepted international order.

US policymakers have long relied on monetary-fiscal coordination to stabilize government debt and inflation, with varying degrees of success (Bianchi, Faccini, and Melosi 2023).
The 1970s coordination collided with oil market disruptions, sparking heightened inflation; by contrast, the 2010s saw coordination offset deflationary forces under favorable supply conditions.
After the pandemic, unprecedented coordination contributed to persistently high inflation because it coincided with disruptions to global supply chains and Russia’s invasion of Ukraine.
Supply disruptions weaken fiscal backing more than demand shocks (Smets and Wouters 2024), explaining why monetary-fiscal coordination is more successful during demand-driven expansions with favorable supply conditions than when large fiscal imbalances coincide with persistent adverse supply shocks.
Policymakers face a dilemma under adverse supply shocks: tighten to defend price stability at the cost of deeper recession and worse fiscal positions, or accommodate inflation to mitigate downturns and ease fiscal burdens at the cost of abandoning price stability.

Geopolitical tensions, rising defense spending, trade fragmentation, population aging, low productivity growth, and heightened exposure to climate and geopolitical risks erode fiscal positions across advanced economies.
With high debt, fiscal adjustment must be gradual—sustainable adjustment will likely require pragmatic tolerance for some controlled inflation.
“Fiscal inflation” can work when temporary and moderate and without causing a disruptive loss of inflation-fighting credibility.
If government bonds are not indexed to inflation, the central bank can smooth or delay price adjustment by buying time for future fiscal corrections and market revisions of fiscal outlooks (Corsetti and Maćkowiak 2024).
Success requires effective communication: authorities must assure the public of their ability to stabilize public debt—via reforms and policies to contain supply-side disturbances—while delivering plausible broad-based productivity gains.

Countries such as the US and the UK have mechanisms that stabilize debt in part through inflation, rooted in explicit rules and unwritten institutional guidelines; the euro area’s lack of a meaningful federal budget and debt complicates this equilibrium.
Anticipated productivity growth from new technologies and improved public spending could boost growth and strengthen long-term fiscal sustainability.
Governments face the challenge of scaling up defense outlays while investing in R&D and innovation; some defense spending could feed expectations of growth-enhancing innovations.
In the face of geopolitical fragmentation, governments may be tempted to raise revenue by taxing trade or embrace financial repression—tighter regulation and capital controls—in hopes of lower borrowing costs; such measures risk increasing vulnerability to stagflationary shocks and provoking disruptive feedback between domestic and uncoordinated international policies.
Extended unconventional collaboration that integrates a wide range of internal and cross-border policies would help keep the world economy on a path to sustainable fiscal adjustment.
Emerging markets face particular challenges: geopolitical shocks can redefine global imbalances and the costs and benefits of export-led policies, capital account liberalization, and exchange rate arrangements with limited flexibility, while risking erosion of credibility in local-currency debt markets.

Enhanced coordination between monetary and fiscal authorities is required given large fiscal imbalances, adverse demographic trends, and geopolitical developments; such coordination can boost credibility of fiscal stabilization but requires careful balancing.
Policymakers may overestimate the scope for reasonable fiscal inflation, downplay benefits of credible inflation-targeting regimes, and exaggerate advantages of noncooperation in international economic relations.
Historical precedent (mid-1960s through the 1970s) suggests that inability to neutralize geopolitical forces—such as OPEC’s leverage over oil prices—can exacerbate inflationary episodes when fiscal imbalances are already elevated.
Macroeconomic stability is a global public good; geopolitical stability, adherence to accepted legal norms, and effective international institutions are essential backstops to preserve central bank independence and macroeconomic stability.

Source: Giancarlo Corsetti and Leonardo Melosi, "Policy Coordination for Fractured Times," F&D Magazine.

Policy Coordination for Fractured Times
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