The Janus-faced fiscal-monetary policy mix [Ten issues to watch in 2023]

Written by Martin Höflmayr.

The Russian war of aggression against Ukraine has drastically reversed the dynamics of the unexpectedly strong economic recovery from the COVID-19 pandemic in Europe. Supported by decisive fiscal and monetary policies, the EU economy was already back to its pre-crisis output levels in the third quarter of 2021, though with large differences across Member States. The economic growth dynamic extended to the second quarter of 2022, firmly entrenched in a monetary and fiscal policy mix aligned in their goal to support the recovery. In 2023, the policy objectives of fiscal and monetary policy, like a Janus face with sharply contrasting characteristics, face significant trade-offs between taming inflation and mitigating the impact of high energy prices.

Why did we get two opposing faces?

Alongside the humanitarian impact of the war, the EU has been hit by a substantial shock in import prices, in particular energy prices, which has severely dented the economic outlook since early 2022, prompting concerns about more persistent inflation, a cost-of-living crisis and public debt sustainability. As a result, since early 2022, economic forecasts have seen significant downward revisions (Figure 2). Analysis by the IMF serves as a stark illustration of the EU’s severe economic losses from the war. In 2023, Europe’s output will be nearly half a trillion euros lower than pre-war forecasts. According to the latest Commission forecast, the EU is expected to experience a ‘technical recession‘, i.e. two consecutive quarters of shrinking output. This forecast crucially hinges on the assumption that the EU can avoid crippling gas shortages, thus significantly tilted to the downside. Moreover, inflation has increased to record high levels worldwide so that central banks across the globe entered a synchronised monetary policy tightening cycle. In the EU, energy prices have been the main contributor to inflation, especially gas and electricity tariffs. However, price pressures are starting to translate into broader price dynamics as the share of items in the product basket above 2 % – the central banks’ inflation target – has increased significantly (Figure 3). At the same time, the current economic environment is underpinned by the strongest labour market in decades. Unemployment rates are at record low levels, while participation and employment rates are at record highs. Despite the looming recession, unemployment is expected to increase only marginally due to high vacancy rates and labour shortages.

How to synchronise contradictory voices

Against this backdrop of trend reversals, there is an increasing wedge between fiscal and monetary policy objectives. During the pandemic, both fiscal and monetary policies worked in tandem and complemented each other. In an environment of slowing growth, high inflation, elevated post-pandemic debt levels and eroding real incomes, fiscal and monetary objectives are diverging.

On the back of rising energy bills, eroding the purchasing power of households and companies, governments are trying to cushion the impact on real incomes and investment activity. The resulting expansionary fiscal policies, maintaining demand through measures that mitigate the impact of high energy prices, could undermine the disinflationary policy currently being conducted by central banks to bring down inflation through reducing support for demand. Monetary authorities could therefore be forced to increase policy rates even further at the cost of larger output and employment losses. According to the autumn forecast of the European Commission, Member States’ fiscal policy measures to mitigate the social and economic impact of high energy prices will amount to 1.2 % of gross domestic product (GDP) in 2022, and 1 % in 2023. So far, such measures have been implemented in a timely manner, however more than 70 % of them were untargeted. Resilient labour market conditions allow governments to focus on targeted cost-of-living policy interventions, as compensating for higher inflation is supporting wage growth while risks of a wage-price spiral have been contained so far. Furthermore, reducing energy dependence on imported fossil fuels can be expected to exert upward pressure on prices of a broad range of products during the transition period. Therefore, fiscal restraint can help to tackle inflation, and, as argued by the ECB, fiscal measures need to be temporary and tailored to the most vulnerable households and businesses, in order for fiscal policy not to stoke inflation.

The monetary side in the policy mix centres around price stability. To bring inflation back from record high levels to the 2 % target, the ECB has so far followed the synchronised tightening cycle of central banks around the world. On the one hand, it tackled inflation by front-loading four consecutive policy rate increases by a cumulative 2.5 percentage points; and on the other hand, the ECB countered fragmentation concerns by creating a new policy tool, the Transmission Protection Instrument. However, evidence suggests that simultaneous central bank measures change the trade-off between the growth and inflation impact of monetary policy tightening, as the negative impact on GDP is larger but the impact on inflation is smaller, due to the muted foreign exchange rate channel. Forceful monetary policy tightening would also have an effect on financial conditions. Rising borrowing costs could amplify existing financial vulnerabilities in the corporate sector. Increasing risk premia of sovereign debt and debt spreads across EU countries could raise the risk of financial fragmentation that has given rise to concerns about fiscal dominance. The policy dichotomy is further complicated by the fact that it is, as yet, unclear whether the supply shocks have durably depressed potential output. Evidence suggests that destroying demand also affects supply through scarring effects. Therefore, excessive monetary tightening could result in a permanent loss of output as productive capacity adjusts to persistently lower demand. To preserve productive capacity in a contractionary economic environment is the balancing act of targeted energy and fiscal policies on one side and a sufficiently large withdrawal of monetary policy accommodation on the other side. Thus, monetary authorities must tread a narrow path between taming inflation and averting an excessive decline in demand.

The economic outlook is heavily influenced by the evolution of the geopolitical situation and its reverberations in commodity markets. The impacts on growth and inflation are in opposite directions, which significantly complicates policy coordination. The challenges from COVID and the war on Ukraine pose formidable challenges to reconciling fiscal and monetary policy trade-offs.

Read the complete in-depth analysis on ‘Ten issues to watch in 2023‘ in the Think Tank pages of the European Parliament.