Fiscal and monetary policies in opposite directions and inflation – 05/22/2023 – Cecilia Machado

During the pandemic, fiscal and monetary policies mostly moved in the same direction: they were expansionist. In addition to the increase in expenses, which made it possible to sustain income, several credit programs and debt renegotiation at lower interest rates were implemented. These stimuli resulted in high indebtedness —raising questions about the debt sustainability and solvency of governments— and widespread inflationary pressures, further fueled by disruptions in supply chains and the reorganization of production in response to geopolitical uncertainties. With the end of the pandemic, the reversal of these expansionist policies became necessary.

Pursuing their mandates, central banks, both in emerging and developed countries, initiated cycles of interest rate hikes, placing monetary policy in restrictive territory to contain the inflationary escalation. But in many countries the reversal and containment of fiscal stimuli still encounters resistance. Thus, the question arises: would fiscal and monetary policies in opposite directions be able to tread the best path for the convergence of inflation in an environment of economic recovery?

Central banks and governments have specific mandates for conducting their monetary and fiscal policies. But many times these mandates overlap and the action of one can interfere with the objective of the other. An example comes from the impacts that monetary and fiscal policies have on inflation, even though the mechanisms and channels through which they act are quite different.

In the case of monetary policy, raising interest rates reduces inflation through a contraction in consumption and investment. This rise in interest rates is accompanied by debt growth, both through debt costs and through the reduction in revenue that accompanies the slowdown in activity. In the case of fiscal policy, a reduction in spending also slows down demand, but, in this situation, interest rates may even drop, as when there is a reduction in the risk premium that accompanies a falling debt trajectory.

Thus, the need for a restrictive monetary policy in an environment of expansive fiscal policy generates indirect effects on the actions of central banks. When this occurs, monetary authorities need to act even more aggressively and incisively to combat inflation, with additional effects on debt growth. Otherwise, a lenient attitude towards inflation could lead to the weakening of expectations and a more inertial inflationary dynamic.

It’s in Brazil? Are monetary and fiscal policies coordinated and heading in the same direction? Or are they going in opposite directions, with considerations about the indirect effects of one on the other? Everything indicates that monetary policy has been in restrictive territory since 2021, and today the ex ante real interest rate (the one that discounts inflation expectations 12 months ahead) has already reached just over 7%, well above any estimate of the neutral rate (the one at which inflation remains stable and output grows at its potential). The slowdown in credit and the increase in defaults help to corroborate this view.

Despite this, several activity and labor market indicators remain resilient, consistent with an expansive fiscal scenario. The transition PEC contracted a fiscal expansion of 2% of GDP in 2023, and the new framework, which despite predicting the end of the primary deficit already in the coming year, has not yet been able to list a plan that corroborates the increase in expected surpluses . In the opposite direction of monetary policy, fiscal policy seems to be expanding.

A restrictive monetary policy combined with an expansionary fiscal policy is like a car accelerating with the handbrake on. It is in this sense that there are gains in the coordination of monetary and fiscal policies. Or, better said, there are gains when one recognizes the indirect effects of an expansionary fiscal policy on inflation. Responsible fiscal consolidation is key to generating a stable macroeconomic environment for solid, balanced and long-term growth.

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