Inflation targets are no match for fiscal neglect

"Inflation is always and everywhere a monetary phenomenon." Milton Friedman's famous dogma looks increasingly quaint today. In the face of unprecedented public debts, yawning budget deficits, and ever-increasing demands on the public purse, the ability of monetary policy to keep a lid on inflation looks an ever more quixotic task. New research reminds investors that it has ever been thus. If inflation is to be tamed, budgetary discipline is always and everywhere the ultimate prerequisite.

The modern consensus that central banks should focus on price stability – preferably summarised by an explicit inflation target – has some well-known flaws. One is that even when realised, low and stable inflation is not a sufficient condition for financial or economic stability. That became clear in 2008 when nearly two decades of stable prices across many advanced economies failed to prevent – and indeed probably contributed to – the build-up of colossal financial imbalances which imploded in a catastrophic crash. As two doyens of the central banking world put it at the time, two "NICE" (Non-Inflationary, Constant Expansion) decades led to a nasty "bust without a boom".

Another drawback is that while low inflation itself is desirable under ordinary economic conditions, it is not always so. At times of acute fiscal or economic stress – for example, when debts have accumulated to unsustainable levels or when the labour market is adjusting to a major shock – inflation can be a crucial macroeconomic boon. That's why in 2008 the Harvard University economist Ken Rogoff advocated high inflation as the safest way of defusing the risks inherent in the debt overhang following the collapse of the US housing bubble; and why in 2010, then-Bank of England governor Mervyn King justified having tolerated inflation at 5 percent for two years in place of higher unemployment. Price stability is not an end in itself. Sometimes there are bigger fish to fry.

These two niggles with inflation-targeting are now well known. Some central banks have even tweaked their mandates to correct for them. After 2008, central bankers committed to incorporating financial stability into their decision-making by monitoring asset prices, balance sheets, and excessive risk-taking. The Bank of England, for example, established a Financial Policy Committee to monitor systemic financial risks alongside its rate-setting Monetary Policy Committee. As for inflation targets themselves, some central banks are now explicit in treating them less dogmatically. Thus in 2020 the Federal Reserve adopted "Flexible Average Inflation Targeting" in place of its prior strict 2 percent objective – giving the US central bank some room for manoeuvre.

Yet there is a third and more fundamental question hanging over inflation targeting which goes beyond what any such add-ons can correct: how effective it is.

On the face of it, the most compelling argument in its favour is the so-called "Great Moderation" itself: the three decades after 1990 when the high and volatile inflation of the 1970s and 1980s gave way to price stability. Yet the suspicion has always lingered that much of the near-worldwide death of inflation was really due to structural changes in the global economy: the widespread implementation of privatisation and deregulation over the same period, and the influx into the global labour force of hundreds of millions of new workers as a result of the collapse of communism, the opening up of China, and the liberalisation of global trade.

It might seem reasonable to assume that improvements in monetary policy at least played a supporting role. Yet a recent study of 27 advanced economies published by the European Central Bank argues even that isn't quite true. While the overall quality of institutions in a country – its legal system, its quality of government, and so on – is an important driver of inflation outcomes, the paper concludes, "central-bank specific factors such as independence, exchange rate regimes, or inflation targeting show no significant impact". The popularity of inflation-targeting, it seems, was as much a consequence of the Great Moderation as its cause.

Another recent paper,– this time from the Bank of England – adds a fourth complication to the mix. Its authors offer a revisionist analysis of the other founding myth of modern central banking: the great inflation of the 1970s. Economists have traditionally explained the spike in UK inflation, which peaked at 25 percent in 1975, as the consequence of an inadequate monetary policy response to the first oil price shock of 1973. The new study, however, demonstrates convincingly that the British public's inflation expectations had already slipped their anchor in the late 1960s, when successive UK governments abandoned debt-stabilisation as the principle guiding of fiscal policy and adopted Keynesian demand management techniques instead. Expectations only recovered their moorings in the 1980s once Margaret Thatcher's government had once again made the sustainability of the public debt the focus of fiscal policy. The authors conclude that it was ultimately shifts in the fiscal regime, not monetary policy, that both pumped up and deflated the inflationary decade. In this important sense fiscal dominance – where government borrowing shapes monetary policy – is not an exception but an unavoidable fact of economic life.

For investors, the lesson of these four challenges to the modern monetary policy consensus is simple – and unfortunately bleak. In today's era of persistent deficits and big debts, it would be a mistake to bet on central banks keeping inflation down. Deft management of monetary policy is certainly a necessary condition for keeping prices in check. But if fiscal policy loses its discipline, even the most skilful central bankers will not be able to help. The resulting destabilisation of inflation expectations will overwhelm monetary policy.

In its latest review of public finances around the world, the International Monetary Fund paints a baleful scene. Around the world, "looming expenditures on defense, natural disasters, disruptive technologies, demographics, and development" are colliding with "sharp political red lines against tax increases and diminished public awareness of fiscal limits." The IMF forecasts that global public debt will top 100 percent of GDP by 2029 – its highest level since 1948.

"A sound monetary policy needs to be buttressed by a prudent fiscal stance" was UK finance minister Nigel Lawson's understated verdict on the trauma of the previous two decades in 1988. It looks like we are about to rediscover what he meant. With apologies to Friedman: in the end, inflation is always and everywhere a fiscal phenomenon.