ECB Research Bulletin: Central Fiscal Authority Could Help Avoid Low-Inflation Trap

24 June 2021

By David Barwick – FRANKFURT (Econostream) – When monetary policy is up against the lower bound, fiscal policy is called on to avoid a self-fulfilling low-inflation trap, according to a research bulletin published Thursday by the European Central Bank.

This finding argues for the centralisation of fiscal authority in the euro area, the bulletin inferred.

In a low inflation trap, nominal interest rates are too low to be deployed to boost below-target actual and expected inflation, a situation with self-fulfilling elements that Japan is often considered to be in. ‘More recently, persistent inflation shortfalls across the industrialised world have raised concerns that other jurisdictions, too, may be on the verge of getting caught in a Japanese-style low-inflation trap’, the research bulletin said.

In the model the bulletin reported on, whether the economy gets trapped under persistently low inflation or achieves a benign equilibrium cannot be determined exclusively by monetary policy, and ‘occasional declines in people’s confidence can, collectively, drag the economy into a low-inflation trap.’

When fiscal policy can influence the economy and is not subject to constraints akin to monetary policy’s lower bound, the trap can be avoided, the bulletin said, via an increase in government spending that takes over when the central bank can go no further.

This spending increase mounts with the economic contraction and with the distance from the inflation target: ‘in principle, the fiscal authority has to be willing to raise government spending by whatever amount is needed to more than offset the effects of a possible drop in private sector confidence’, according to the bulletin.

Under such circumstances, with private economic agents aware of fiscal policy’s reaction function, the model shows the low-inflation trap consistently avoided, the bulletin reported.

Indeed, in the model used, the fiscal authority would not even have to intervene, as expectations would remain anchored, but in practice, the author said, actual spending would probably be needed.

Given fiscal decentralisation in European Monetary Union, fiscal constraints in some member countries and the difficulty of coordinated action, ‘preventing self-fulfilling low-inflation traps could be another reason to create a central fiscal capacity in Europe’, the research bulletin said.