The Risks of Fiscal Turmoil for Monetary Policy: Some Lessons from History

Friday, October 21, 2011

Economics Working Paper WP11111

The current view of best practice central banking sees the central bank as independent of the fiscal authority pursuing a credible policy rule dedicated to price stability. The assumption behind this conception is that the fiscal authorities will also follow stable policies and aim towards balanced budgets over the business cycle. If the fiscal authorities do not maintain fiscal discipline the central bank will not use its seigniorage to close the gap.

The recent financial crisis and recession in the U.S. and the massive fiscal stimulus package that followed it has led to a fiscal deficit close to 9% and a ratio of debt to GDP close to 90%. In addition, demographics point to ever rising Social Security and Medicare entitlement expenditures and the possibility of even larger deficits and debt ratios in the not too distant future. These facts raise the specter of a disconnect between a relatively stable monetary policy and a relatively unstable fiscal policy and raises the question whether the Fed can insulate itself from the fiscal turmoil.

The Risks of Fiscal Turmoil for Monetary Policy: Some Lessons from History