The keynote lecture of the joint NBU-NBP Annual Research Conference was devoted to an issue, which is topical both for advanced and developing economies.

Alan Auerbach, University of California, Berkeley, spoke about the problem of economic inequality, aging and capital mobility, and their implications for fiscal and monetary policies.

Today, economic inequality and a demographic shift toward older populations in countries around the world are increasing pressures on fiscal policy (in the case of inequality, to address economic need; and in the case of population aging to fund important spending programs targeted toward the elderly).

In his speech, Alan Auerbach took the USA as an example and showed the risks related to these phenomena, focusing on a fiscal gap. He mentioned that projections through 2050 assume that a large part of the fiscal gap stems from old-age spending growth.

Therefore, urgent measures are needed to smooth the negative implications of the two factors for the economy. The keynote lecturer believes that fiscal policy should become more active, though the available tax instruments may fail to produce the expected effect, being limited by the higher mobility of capital that we can observe today.

On the other hand, monetary policy has a very limited number of instruments that could help resolve the problem. Increased inflation that could facilitate replenishing of the budget, will also push up social spending.

At the same time, with high inequality, aging and capital mobility, pressures on the fiscal policy will be fueling pressures, including the political one, on monetary policy and the central bank. Under such circumstances, the independence of a central bank is critically important, and instruments for resolving challenges should be found in the fiscal area rather than in the monetary one.

Monetary policy normalisation in developed economies 

The first panel discussion of the NBU-NBP Annual Research Conference addressed the fiscal implications of monetary policy normalization (returning interest rates to normal levels after a long period of low rates as an anti-crisis measure) in advanced economies.

The panel discussion was open by Alan Auerbach, Professor of Economics and Law from the University of California, Berkley, who focused on the specific nature of, and the challenges faced by, U.S. fiscal and monetary policies. Although the U.S. inflation rate has been almost unchanged over the past three years, and no factors that could lead to a surge in inflation are looming on the horizon, the Fed has decided to raise its Federal funds rate target. Meanwhile, the country’s unemployment rate has hit a low not seen since the Vietnam War, driven by significant fiscal and monetary stimuli.

This has direct implications for fiscal policy. On the one hand, higher interest rates push up debt servicing costs. On the other hand, for replenishing the budget and executing social programs low rates are more of an obstacle than anything else. Indeed, the U.S. economy has taken the unsustainable path of fiscal policy because of the difficulties with meeting social obligations, especially taking into account the country’s demographic situation. Under such conditions, the normalization of interest rates, which will increase budgetary spending on public debt servicing, will limit fiscal space and the United States will have to rely more on monetary policy.

Cecilia Skingsley, a speaker from Sveriges Riksbank, talked about the roles fiscal and monetary policies played in stabilizing the Swedish economy in the 1990s. Among other things, she described Swedish macroeconomic reform that delivered the sustainability of government finances by setting four clear-cut criteria for a balanced general government budget, budgetary spending, balanced local budgets, and consolidated budget debt. In Sweden, fiscal and monetary policies play different roles. Fiscal policy’s largest contribution to economic stability is in maintaining trust in the long-term sustainability of government finances. That is why when demand shocks arise, the government takes little action, letting monetary policy take the lead in stabilizing inflation and demand. However, there is ongoing debate in Sweden whether this approach is effective under the inflation targeting regime, and whether or not it leads to a conflict between fiscal and monetary policies.

Cecilia Skingsley also spoke about the modern challenges faced by Sveriges Riksbank. Effective inflation targeting is impossible without trust to the central bank. However, the monetary policy normalization creates a challenge as it raises financial risks for the central bank that has accumulated government bonds on its balance sheet as a result of quantitative easing.

Kristin Forbes from Massachusetts Institute of Technology, the third participant of the discussion, spoke about the reasons why developed countries find it difficult to bring interest rates back to the pre-crisis levels. She believes that this may be due to several factors: unsteady economic recovery after the crisis, a drop in neutral rates of interest, new shocks that restrain inflation growth, such as lower oil prices and elections, and changes in central banking (new macroprudential tools, increased publicity of central bankers and other).

This brings up a question: how can a central bank determine the right time to normalize its monetary policy and raise the interest rate when standard models do not work? In the opinion of Kristin Forbes, the answer lies in the analysis of inflation data broken down by temporary cycles and the long-term trend that is the signal for hiking the interest rate.