Inflation reduced faster if central bank and governments apply brakes simultaneously

European monetary and fiscal policies are not always in sync

Following the European sovereign debt crisis of 2012, the European Central Bank started easing its monetary policy. At the same time, many national governments in Europe made sharp budgetary cuts. These cuts, which may have been sensible from a national perspective (particularly in countries with high public debts), ran counter to monetary policy and were accompanied by a long period of low inflation and disappointing growth rates. In contrast, policy responses to the COVID-19 pandemic in 2020 were much more aligned: the ECB and national governments responded by easing both monetary and fiscal policies, contributing to a swift economic recovery. Currently, the euro area is once again facing major challenges due to the energy crisis and high inflation. To quell this high inflation, the ECB has raised interest rates sharply and accelerated the wind-down of its asset purchase programmes. Again, however, the effectiveness of monetary policy will in part hinge on the fiscal policies pursued by national governments in Europe. 

Expansionary fiscal policy may dampen impact of tighter monetary policy  

When a central bank tightens its monetary policy, it raises interest rates to lower inflation, partly by depressing consumption. Consumption is strongly influenced by household wealth, which, in turn, is affected by both monetary and fiscal policies. For instance, if the ECB changes interest rates, interest income on savings also changes, and so does the value of financial assets and real estate. Likewise, if governments adjust tax rates, allowances and subsidies, household wealth and disposable income are affected. Fiscal policies that are expansionary and have a strong positive wealth effect can dampen the consumption and inflation response to a tightening of monetary policy.

A new study by economists from DNB and Radboud University corroborates the importance of fiscal policy for the effectiveness of monetary policy. Using an econometric model, the effect of a monetary tightening on inflation is estimated for a group of ten euro area countries, including the Netherlands, while distinguishing between times of contractionary and expansionary fiscal policy. This study shows that when monetary tightening is accompanied by fiscal tightening, the corresponding decline in inflation is larger than when monetary and fiscal policies work against each other (Figure 1). The study also shows that this difference between the effects on inflation is more pronounced during an economic crisis, and when expansionary fiscal policy is driven by increases in government spending rather than tax cuts.

Figure 1 - Average inflation response to monetary policy tightening

Note: The figure shows the average response of inflation to a monetary policy tightening shock of one standard deviation over a three-year period. Vertical axis: percentage points. 

Monetary and fiscal policies both contribute to price stability

The results from the study show that the current high inflation can be brought down faster if monetary and fiscal policies move in the same direction. However, if national governments in Europe and the ECB move in opposite directions, as they did after the European sovereign debt crisis, inflation may well remain high for longer. In that case, the ECB may need to keep interest rates high for longer or raise them further to bring inflation back to its medium-term target of 2%.