4.3  What is the role of fiscal policy within an inflation targeting framework?

4.3.1  Macroeconomic impacts of fiscal policy

The point was made earlier in Section 2.1 that when fiscal policy is not sustainable the monetary authority may be unable to control inflation. Hence, sustainable fiscal policy is a prerequisite of a successful inflation-targeting regime if private agents are well informed and forward looking. Theoretical macroeconomic models evaluating the implications of game-theoretic conflicts between monetary and fiscal authorities have also revealed that fiscal sustainability is not a sufficient condition and that conflicting policy objectives can result in fiscal policy actions frustrating the stabilisation objectives of the monetary policy authority (see for example Buckle and Stemp, 1991). Fiscal policy should not, therefore, be operated entirely independently of monetary policy. But the extent to which fiscal policy should take account of the business cycle in its coordination with monetary policy in achieving short-run macroeconomic stabilisation is not a settled issue.

One view is that when there is an independent inflation-targeting central bank, discretionary fiscal policy need not pay any attention to the cycle. Buiter (2006), for example, argues that limiting the role of fiscal policy in stabilisation to the automatic stabilisers, which arise on the operating budget, is appropriate. He argues public investment expenditure cannot always be immediately switched on or off, or varied in scale, according to the cycle, without causing serious efficiency losses.

In contrast, Allsopp and Vines (2005) argue fiscal policy should take account of macroeconomic stability concerns because fiscal policy influences the mix of policy and therefore the configuration of interest and exchange rates. In particular, they argue that there will be times when fiscal policy will itself be the “shock” to demand and the output gap to which monetary policy must respond. Under normal circumstances the monetary authority will be able to react to a fiscal shock by changing interest rates. However, a lack of policy coordination where a fiscal stimulus is too pro-cyclical may result in monetary policy having to tighten to a greater degree than otherwise to achieve inflation stability. A fiscal expansion that occurs when the economy is operating above trend output will provoke a response from the central bank and require a greater adjustment from the private sector than if a similar expansion had occurred when demand was below trend output. Allsopp and Vines argue that these costs should be taken into account in government fiscal decisions.

The strength of these respective arguments depends on whether the consequences of monetary policy responses are likely to be more damaging than the consequences of discretionary taxation and government expenditure policy that takes account of the stage of the business cycle. The risks of a more active fiscal policy have already been touched on and depend on whether fiscal institutions can be designed in a way so that fiscal policy can take account of macroeconomic stabilisation concerns but not be subject to the political economy risks and the risks of adverse long-term impacts on fiscal structure. The risks for monetary policy include the possibility of adverse effects on productivity (arising from uncertainty and real interest rate fluctuations) and the political economy consequences of higher interest rates or the differential sectoral effects of fluctuations in the real exchange rate that may pose a threat to the sustainability of the framework for monetary policy. These have been issues at the forefront of recent New Zealand debate.

There are, nevertheless, circumstances in which the case for a stronger focus by fiscal policy on the business cycle is more clearly warranted. These tend to be circumstances in which monetary policy is ineffective.

4.3.2  Fiscal policy when monetary policy is ineffective

One circumstance under which monetary policy becomes ineffective is when there is a “liquidity trap” situation, such as that which Krugman (2005) argues applied in Japan during the 1990s. In this environment monetary policy is ineffective to stimulate activity because the nominal interest rate has already hit its lower bound. Arguably the US reached a similar situation after the technology bubble burst at the start of the millennium. Fiscal policy could be used in these circumstances to kick-start growth in domestic demand. The authorities face a dilemma, however, if the combination of low growth and fiscal expansion threatens fiscal sustainability (Allsopp, 2005). This potential problem illustrates the importance of forward-looking monetary policy that not only dampens demand in the face of expansionary shocks, but also tries to avoid the emergence of a “liquidity trap” (Ahearne, Gagnon, Haltmaier and Kamin, 2002).[33]

Another circumstance in which the effectiveness of monetary policy is compromised is where the financial system impedes the effective operation of monetary policy instruments. For example, according to Gianella (2007), the level of monetization and financial intermediation by banks and financial markets is not sufficiently developed in Russia to facilitate a credit channel for central-bank induced interest rates changes. The level of financial system development evidently hampers the efficient circulation of liquidity and tends to generate interest rate volatility. In circumstances when domestic inflation and the real exchange rate are being significantly influenced by oil price-generated income growth, monetary policy has not been particularly effective and fiscal policy has been the primary instrument of macroeconomic stabilisation policy. One of the factors motivating this assignment has been concern that, despite low effectiveness, reliance on monetary policy to dampen the inflationary consequences of the terms of trade growth could accentuate the real exchange rate appreciation and compromise efforts to diversify the production base of the Russian economy.

Different concerns have been raised in New Zealand about the effectiveness and impact of monetary policy in the current environment. A number of factors have come together over the most recent business cycle upswing to test the robustness of monetary policy as an effective instrument for macroeconomic stabilisation policy. One of those factors has been, as in Russia, a strong rise in the commodity terms of trade and potential implications of further appreciation of the real exchange rate.

The recent New Zealand business cycle upswing has been associated with a strong migration inflow, an exceptional rise in housing demand and household wealth and recently an exceptional rise in dairy prices. Fiscal policy has also been cited by the Reserve Bank as one factor stimulating domestic demand (Reserve Bank of New Zealand, 2007). As housing tends to be a larger share of total wealth of New Zealand households than in most other developed economies, the potential wealth effects of rising real house prices may be stronger than in other countries with consequentially more significant implications for domestic demand.

Moreover, some have argued that financial developments, including convergence of long-term interest rates on international rates, robust international financial arbitrage (the ‘carry trade’) and mortgage innovations, have combined to alter the way domestic monetary policy impacted on demand particularly during 2005 to 2006 (see for example the discussion in Grenville, 2006). As a consequence, the transmission channel for monetary policy, it is argued, shifted more toward short-term interest rates and the exchange rate to the extent that the New Zealand dollar rose during 2007 to the highest level against the US dollar since it was floated in 1985. Concerns as to the impact of the appreciation of the exchange rate on exporters have been one of the motivations for recent assessment of the merits of the present macroeconomic policy framework, despite the fact that the impact of exchange rate volatility on long-run growth is unclear.[34]

New Zealand monetary policy has therefore recently had to contend with some typical demand shocks, but in an evolving international and domestic financial environment that altered the weights on the transmission mechanisms of monetary policy. Policy-makers have been active in evaluating the extent to which fiscal policy could be more counter-cyclical and could better coordinate with monetary policy and whether regulations and taxation policy could be improved to ameliorate the housing cycle.[35]