In the face of runaway inflation, higher interest rates are inevitable, but fiscal policy should be doing some of the work of curbing inflation too, argues a new report from Scotiabank Economics.
So far, the world’s central banks have largely been left to combat inflation alone, it said.
“Under normal circumstances this would be appropriate, but these are not normal circumstances,” the report said, explaining that fiscal policy should be recruited to join the fight.
The report argued that inflation is partly the fault of expansionary fiscal policy in the first place.
“We believe a large part of the strength of inflation can be linked to what was effectively a globally coordinated fiscal boost to protect economies against the worst of the pandemic’s economic and financial impacts,” it said.
Now, relying solely on rate hikes to curb inflation will inflict output reductions on the private sector, it argued.
Given that, the report suggested that throttling back government spending could help limit inflation and reduce the pressure for large damaging rate hikes.
“A less supportive fiscal policy would take some adjustment burden away from the private sector, but also have a much more immediate impact on inflation,” it said.
Still, the report acknowledges that cutting government spending is easier said than done, and that many forms of government spending (such as child care and education) are necessary investments.
“We would not advocate a slash and burn approach but careful and targeted reductions in spending,” it said.
“The simple reality is that firms and households are going to be making trade-offs as they incorporate higher inflation and financing costs in their budgets. It seems unreasonable for governments not to do the same and in so doing reduce the adjustment required by the private sector,” it said.