The Governor of the Bank of England is currently telling us that the NICE (non-inflationary consistently expansionary) decade is over. A period of low inflation, stable business cycles and a flat profile of low interest rates has come to an end. Rising inflation, triggered by high commodity prices, and financial stress, in the wake of turmoil in asset backed securities, have killed off the NICE decade.
This unravelling has brought about a dramatic shift in monetary policy, especially in the United States. Given the level of inflation a Taylor rule would be hard pressed to account for the recent behaviour of the Federal Funds rate. Some commentators argue that longer term inflation expectations are shifting upwards due to high levels of current inflation and either perceived lack of concern by some central banks or doubts about their ability to deliver low inflation in these circumstances.
But there are also other reasons to be concerned about longer term inflation trends. Since the early 1970s OECD governments have experienced a sharp increase in debt levels (see Figure 1). Although a number of countries have, to varying degrees, recently stabilised or reduced their debt burdens these still remain high by the historical standards of peacetime. With an imminent slowdown likely to lead governments to place even less focus on fiscal rectitude (see for instance the recent actions of the UK government) and with large fiscal deficits forecast in decades to come from age related spending these debt levels are forecast to rise yet further. In the absence of outright default the fear is that governments will resort to monetising this debt and creating inflation. The concern is that regardless of the inflation aims of central banks, longer term inflation trends will be driven by fiscal influences.
In a paper with Chryssi Giannitsarou of Cambridge University (Inflation Implications of Rising Government Debt NBER Working Paper 12654) we examine this issue for some leading industrial nations. We do so by considering the government’s intertemporal budget constraint and reviewing the period 1960 to 2005. The intertemporal budget constraint is key for an analysis of fiscal policy and effectively says that, absent default, current government liabilities (debt+money) have to be matched by the net present value of future surpluses. We use this framework to seek answers to three questions i) how sustainable is current fiscal policy? ii) how have governments in the past achieved debt sustainability? and iii) what implications does this have for longer term inflation trends?
At the heart of our analysis is a long term relationship between government debt and monetary liabilities on the one side and the primary surplus on the other. For given expected values of future interest rates, growth rates and money holdings there has to be a fixed relationship between liabilities and the primary surplus. If the primary surplus is too small relative to current debt then fiscal policy is not sustainable and will have to be adjusted. We can use our theoretical framework and econometric estimation to estimate the current degree of imbalance in fiscal policy given this long term relationship. We can also go back historically and see how governments have corrected fiscal policy to achieve long run balance. In this way we can answer the first two questions (is policy sustainable? How have governments achieved sustainability in the past?).
Figure 2 shows our estimates of these fiscal imbalances. A large positive number suggests that the primary surplus is too small relative to the level of debt and a large negative number the opposite. Therefore the larger the number the more the need to tighten fiscal policy in order to achieve long run sustainability. Figure 2 suggests that Canada and Germany are broadly in balance but the remaining countries have all seen a deterioration in their fiscal position in recent years. In the case of Japan the imbalance is at a historical high, for US, UK and Italy the numbers are approaching previous highs.
Figure 2 also shows that the period since 1960 has witnessed considerable swings in our measure of fiscal imbalance. Clearly countries do adjust their behaviour in order to ensure that the intertemporal budget constraint holds. This leads on to our second question – how do they achieve fiscal balance? In terms of our framework there are 5 channels through which fiscal policy can be brought into balance i) changing the primary surplus ii) issuing monetary liabilities iii) changes in the real interest rate iv) inflation v) changes in Real GDP growth (as this leads to changes in the Debt to GDP ratio).
We answer this question by performing a variance decomposition of our model. The results are striking. We find that somewhere between 80-100% of fiscal imbalances are corrected by shifts in the primary surplus. We also find a minor role for inflation (0-10%) and for variations in the growth of GDP (0-20%). In other words, and contrary to popular wisdom, governments do respond to high debt by long run adjustments in their fiscal position. A reliance on inflation plays only an extremely minor role. This conclusion is backed up by performing simple forecast tests for whether our measure of fiscal imbalance has any predictive ability for future inflation. The evidence is weak that estimates of large fiscal imbalances have a significant effect on future inflation. There is some evidence of an effect on inflation between 2 and 5 years out but at significance levels that reveal only a very minor influence.
So what do these results suggest about future inflation trends? Basically that current debt levels and any near term deterioration in the fiscal position is unlikely to have a significant impact on longer term inflation trends. Looking at the period 1960-2005, when government debt showed a substantial increase, we find that the influence of fiscal readjustment on inflation to be minor. The fact we find only a limited role for fiscal policy suggests that variations in inflation in the 1970s were about the effectiveness, or otherwise, of monetary policy. This is not to argue that the NICE times will continue into the future and inflation will remain low. Whether that happens will depend upon the ability of central bankers to withstand rising inflationary pressures from fuel and commodities. What our analysis suggests is fiscal policy wont be a determining influence on the ability of monetary policy to tame inflation.