Gulnara Nolan

Government and central bank coordination in a low inflation world

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In my previous posts on the liquidity trap and about US Treasury bond purchases I have mentioned that central banks and governments should coordinate their policies as a part of unconventional monetary policy when the interest rates are near the zero lower bound and inflation is persistently low.

However, there are costs and benefits associated with any coordination game. The benchmark coordination model and the restricted version of it are well described in English, Erceg, Lopez-Salido 2017. 

Here stimulus is given through a money-financed program, where the Treasury increases government spending (eg through cuts in taxation, investment in infrastructure projects).  This bears a resemblance to the “helicopter drops” originally discussed by Friedman 1969.  The central bank in turn directly finances these expenses through the bond purchases.  Although this seems like a scary new world at first, as was noted in posts in 2013 (here by a different author and elsewhere), it is a sensible part of stabilisation policy when we hit the zero lower bound.

However, although theoretically this model seems like a valid option to boost the price level up through the boost in output, it has a non-manageable high inflation risk. High inflation “fear” comes from the perception that it will be hard to communicate to public this new approach to keep long-term inflation expectation lower and high commitment cost for the central bank.

English et al suggest that it isn’t all or nothing – and instead the central bank can simply commit to responding “less quickly” to fiscal stimulus than it normally would.  This is a similar principle to forward guidance.

Ultimately, it is strange to talk about “risks to inflation” at the same time we are saying we want inflation to be higher.  If some level of money financing is necessary to generate sufficient demand/inflation then it appears to be a clear way of avoiding a Japan style lost decade (or three decades as it is now).

If a central bank wants to generate inflation it can – it just needs to make sure it coordinates with its friends (fiscal authorities), and uses its “credibility” to indicate that it really does want to.