June 15, 2017
Monetary and fiscal policies interact in complex ways. Yet modern institutional arrangements typically feature a strict separation of responsibilities. For example, the central bank targets inflation and smooths business cycle fluctuations, while the fiscal authority agrees to respect its budget constraint and to support financial stability by maintaining the safe asset status of its debt. This gives governments the freedom to pursue a multiplicity of economic and social objectives (in IMF parlance, inclusive growth).
This separation of responsibilities typically works well, but can come at a cost as it limits the potential benefits that arise when fiscal and monetary policy work together. While in normal times the forgone benefits may be small, in more extreme situations the benefits of coordinated policy are much larger.
By looking at the case of low inflation in Japan, we illustrate—in particularly difficult circumstances—how vital it is for these policies to work together. Good coordination between monetary and fiscal policy is key and calls for policies that are:
- comprehensive—exploiting the full range of synergies between monetary, fiscal, and appropriate structural policies; and
- consistent—anchoring long-term expectations by demonstrating a clear commitment of monetary, fiscal and structural reform policies toward common objectives.
Japan’s low inflation
Japan is an obvious candidate for taking better advantage of the synergies between monetary and fiscal policies. Inflation is well below target after decades of depressed nominal GDP growth, despite the Bank of Japan’s efforts to push the boundaries of monetary policy innovation—including the introduction of yield curve control in September 2016.
However, a lack of consistency in fiscal policy has undermined the effectiveness of monetary policy. Fiscal plans have been caught between the short-term need to help monetary policy escape the low inflation target, and the very clear medium-term priority of reducing Japan’s large and unsustainable burden of public debt.
The government could build credibility by introducing a policy framework wherein policy actions are data-dependent—so as to promote the achievement of crucial policy objectives, such as inflation or price level targets. If the government feels compelled to tighten certain policies sooner, they should introduce temporary offsetting measures to continue to support progress toward reflation. The resulting higher nominal GDP growth would also have the added benefit of helping reduce the real burden of the debt.
Of course, such conditional policies potentially carry fiscal risks: if the requisite target is not met, then continued fiscal stimulus could imperil debt sustainability. A consistent and comprehensive approach therefore also requires a framework to manage public sector balance sheet risks that mitigates the financial stability risks from a potential loss of safe asset status for Japanese government bonds.
So, as well as being oriented toward key policy objectives, deficits must be offset by real future surpluses. To avoid the appearance of policy inconsistency, the government should tighten fiscal policy gradually, and consistently with the economic cycle. Such an approach should also include structural reforms that boost future surpluses, for example, measures that close wage gaps.
We should also be clear that fiscal policy should be sustainable, taking as given that the central bank has designed monetary policy to achieve the inflation target. It may seem tempting to instead spend without the promise of (or even ruling out) future tax raises, in the hope that the price level rises to equate to the real values of debt and future surpluses. But this idea, which invokes the so-called Fiscal Theory of the Price Level, assumes that the safe asset status of government debt is guaranteed.
The risk of such a policy, which relies on the shaky assumption that Japanese consumers have very particular expectations of future policy, is that a bond market scare occurs and government bonds lose their safe asset status. This would then relegate monetary policy’s role to that of guaranteeing fiscal solvency (by guaranteeing the promised nominal payments on government bonds), precluding its use in stabilizing inflation and anchoring inflation expectations. This would destroy policy credibility.
The debate on Japan’s consumption tax increase is a good example to illustrate the importance of consistency and credibility. The planned consumption tax increase has been postponed twice: once from 2015 to 2017, and again until 2019, in fear of a negative impact on growth. This policy reversal and the associated lack of a credible anchor has reduced the effectiveness of fiscal policy.
In our view, a pre-announced, gradual increase of Japan’s consumption tax rate, offset by temporary fiscal measures when necessary, remains a preferred option. The gradual increase should continue until the tax rate reaches a medium-term level that ensures fiscal sustainability. This approach will help raise inflation expectations and has high revenue potential given the relatively low level of revenue collected from the consumption tax in Japan, compared with VAT collections in other Organization for Economic Cooperation and Development countries. In the process, Japan should preserve its single rate, which makes its consumption tax system simple, and constitutes an important structural advantage.
The experience of low inflation in Japan has a clear message for the interaction between monetary and fiscal policy. And that message is in such extreme circumstances, macroeconomic policies will only be successful if they take full advantage of the synergies of different policies working together.