Unprecedented policies will be needed to respond to the next economic downturn. Monetary policy is almost exhausted as global interest rates plunge towards zero or below. Fiscal policy on its own will struggle to provide major stimulus in a timely fashion given high debt levels and the typical lags with implementation. Without a clear framework in place, policymakers will inevitably find themselves blurring the boundaries between fiscal and monetary policies. This threatens the hard-won credibility of policy institutions and could open the door to uncontrolled fiscal spending. This paper outlines the contours of a framework to mitigate this risk so as to enable an unprecedented coordination through a monetary-financed fiscal facility. Activated, funded and closed by the central bank to achieve an explicit inflation objective, the facility would be deployed by the fiscal authority.
• There is not enough monetary policy space to deal with the next downturn: The current policy space for global central banks is limited and will not be enough to respond to a significant, let alone a dramatic, downturn. Conventional and unconventional monetary policy works primarily through the stimulative impact of lower short-term and long-term interest rates. This channel is almost tapped out: One-third of the developed market government bond and investment grade universe now has negative yields, and global bond yields are closing in on their potential floor. Further support cannot rely on interest rates falling.
• Fiscal policy should play a greater role but is unlikely to be effective on its own: Fiscal policy can stimulate activity without relying on interest rates going lower – and globally there is a strong case for spending on infrastructure, education and renewable energy with the objective of elevating potential growth. The current low-rate environment also creates greater fiscal space. But fiscal policy is typically not nimble enough, and there are limits to what it can achieve on its own. With global debt at record levels, major fiscal stimulus could raise interest rates or stoke expectations of future fiscal consolidation, undercutting and perhaps even eliminating its stimulative boost.
• A soft form of coordination would help ensure that monetary and fiscal policy are both providing stimulus rather than working in opposite directions, as has often been the case in the post-crisis period. This experience suggests that there is room for a better policy – and yet simply hoping for such an outcome will probably not be enough.
• An unprecedented response is needed when monetary policy is exhausted and fiscal policy alone is not enough. That response will likely involve “going direct”: Going direct means the central bank finding ways to get central bank money directly in the hands of public and private sector spenders. Going direct, which can be organised in a variety of different ways, works by: 1) bypassing the interest rate channel when this traditional central bank toolkit is exhausted, and; 2) enforcing policy coordination so that the fiscal expansion does not lead to an offsetting increase in interest rates.
• An extreme form of “going direct” would be an explicit and permanent monetary financing of a fiscal expansion, or so-called helicopter money. Explicit monetary financing in sufficient size will push up inflation. Without explicit boundaries, however, it would undermine institutional credibility and could lead to uncontrolled fiscal spending.
• A practical way of “going direct” would need to deliver the following: 1) defining the unusual circumstances that would call for such unusual coordination; 2) in those circumstances, an explicit inflation objective that fiscal and monetary authorities are jointly held accountable for achieving; 3) a mechanism that enables nimble deployment of productive fiscal policy, and; 4) a clear exit strategy. Such a mechanism could take the form of a standing emergency fiscal facility. It would be a permanent set-up but would be only activated when monetary policy is tapped out and inflation is expected to systematically undershoot its target over the policy horizon.
• The size of this facility would be determined by the central bank and calibrated to achieve the inflation objective, which could include making up for past inflation misses. Once medium-term trend inflation is back at target and monetary policy space is regained, the facility would be closed. Importantly, such a set-up helps preserve central bank independence and credibility.
The most extreme case of monetary and fiscal coordination is pure monetary financing of government debt. That is, the central bank permanently increases its balance sheet to purchase government debt and facilitate the additional spending or directly inject money into the economy through a so-called helicopter drop. Helicopter money is named after Milton Friedman’s analogy that former Fed Chair Ben Bernanke referenced in a well-known 2002 speech on what extreme measures Japan could take to defeat deflation1 . Helicopter money puts central bank-created money directly in the hands of spenders – whether households, businesses or the government – rather than relying on indirect injections or incentives, such as lower interest rates. Tax cuts or public spending could be explicitly financed by an increase in the stock of money (Turner 2015, Gesell 1916/2007)2 .
We would highlight two key points on helicopter money. First, the fiscal expansion it represents – for example a tax rebate – needs to coincide with a boost in the stock of money. This ensures that any increase in interest rates is limited and there is no crowding out of private investment. Second, this boost to the stock of money has to be permanent. Otherwise, the money might not be spent if the increase is expected to be reversed in the future. If these conditions are met and helicopter money is delivered in sufficient size, it will drive up inflation – in the long run, the growth of money supply drives inflation. Monetary financing of fiscal expansion is not new – indeed it is as old as the first case of hyperinflation.
Monetary financing happened frequently until the early 1980s in many DM countries: Italy, France, Sweden and in the UK until the early 1990s. It came to an end when central banks got serious about controlling inflation after the mistakes of the 1970s. As the chart below shows, central bank government bond holdings as a share of the overall debt are still below historical peaks even with all the QE of the past decade. Central banks were made independent with a mandate to limit inflation and in some cases were banned from directly funding government budget deficits. The extreme cases of monetary financing getting out of hand are well known and have a name: hyperinflation. Examples include the Weimar Republic in the 1920s as well as Argentina and Zimbabwe more recently.
That highlights the main drawback of helicopter money: how to get the inflation genie back in the bottle once it has been released. As noted above, history is littered with examples of how central bank money printing leads to runaway inflation or hyperinflation. Yet there is little experience in using helicopter money to generate just-enough inflation to achieve price stability. History as well as theory suggests large-scale injections of money are simply not a tool that can be fine tuned for a modest increase in inflation.
Going direct: contours of a framework
It is unlikely a more stimulative policy mix will happen on its own, while unconstrained monetary financing presents important risks. We believe a more practical approach would be to stipulate a contingency where monetary and fiscal policy would become jointly responsible for achieving the inflation target. To be sure, agreeing on the proper governance for such cooperation would be politically difficult and take time. That said, here are the contours of a framework:
• An emergency fiscal facility – that we refer to as the standing emergency fiscal facility (SEFF) – would operate on top of automatic stabilisers and discretionary spending, with the explicit objective of bringing the price-level back to target.
• The central bank would activate the SEFF when interest rates cannot be lowered and a significant inflation miss is expected over the policy horizon. See the SEFF funding level in the stylised chart at top below.
• The central bank would determine the size of the SEFF based on its estimates of what is needed to get the medium-term trend price level back to target and would determine ex ante the exit point. Monetary policy would operate similar to yield curve control, holding yields at zero while fiscal spending ramps up – see the yield at zero in the middle chart below. (The charts help sketch out the concept but are not intended to be a precise representation of how it might work.)
• The central bank would calibrate the size of the SEFF based on what is needed to achieve its inflation target – the red dotted line in the bottom chart below.
This proposed framework could include Bernanke’s temporary price-level target where the central bank commits to not only reach its inflation target but make up for past shortfalls (see Bernanke 2017 and our June 2019 work on inflation make-up strategies). Importantly, it complements it by specifying the mechanism – the SEFF – to push inflation higher. This is inspired by Bernanke’s 2016 proposal for a money-financed fiscal programme.
This approach improves on other fiscal approaches to providing stimulus when rates are at the ELB, we believe. Similar to Furman and Summers (2019) and Blanchard (2019), it argues for the use of fiscal policy – yet it does not rely on rates staying below growth for the entire time needed to stimulate the economy. Our proposal stands in sharp contrast to the prescription from MMT proponents. They advocate the use of monetary financing in most circumstances and downplay any impact on inflation.
Our proposal is for an unusual coordination of fiscal and monetary policy that is limited to an unusual situation – a liquidity trap – with a predefined exit point and an explicit inflation objective. Quasi-fiscal credit easing, such as central bank purchases of private assets, could be operated by the SEFF rather than the central bank alone to separate monetary and fiscal decisions.
A credible stimulus strategy would help investors understand what will happen once the monetary policy space is exhausted and provides a clear gauge to evaluate the systematic fiscal policy response. Spelling out a contingency plan in advance would increase its effectiveness and might also reduce the amount of stimulus ultimately needed. As former US Treasury Secretary Henry Paulson famously said during the financial crisis: “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”
This is one way to implement a credible coordination framework. In the next downturn, the loss of central bank independence and uncontrolled fiscal spending are risks. Any framework will need to put boundaries around such policy coordination to mitigate these risks.
The effectiveness and market implications of such a policy framework would depend on whether it is implemented well in advance of the next downturn. If it were, it would increase the chances of the framework being well understood by the markets, underpinning its credibility and efficacy.
In this scenario, this framework would tame current lingering fears that the ELB will constrain policymakers in a recession and prevent them returning inflation and the output gap back to target. The risk of a persistent liquidity trap should decline, justifying less of a negative inflation risk premium in sovereign yields, as reflected in market pricing of inflation expectations below. We would expect long-term bond yields to eventually rise, led by inflation expectations. This would argue for a preference for inflation-linked bonds over nominal instruments.
This relative preference for inflation-linked bonds would be even more pronounced when a downturn materializes. Real yields would decline rapidly as the central bank cuts policy rates towards the ELB. But markets would expect aggressive coordinated monetary and fiscal stimulus to push inflation back to target sooner than would be the case if the facility were not ready to be activated. Longer-run inflation expectations may not fall so far: indeed, shorter-run inflation expectations could overshoot as the central bank aims for above-average inflation during its price-level targeting phase. This would push up the relative returns of inflation-linked bonds over nominal counterparts. It would also boost returns of other real assets in private markets such as infrastructure and property.
The efficacy of such a framework would be undermined significantly if it were only introduced when a downturn is already underway. In this scenario, without a credible way to escape the liquidity trap caused by the ELB, inflation expectations would fall significantly as the recession strikes. At the same time, the compression in inflation expectations would prevent real policy rates from falling sufficiently to lift demand. Under this scenario, only when the coordination framework is finally introduced would inflation expectations begin to creep back up. This scenario would argue for a preference of nominal bonds over inflation-linked instruments.
An effective implementation of this coordinated framework has market implications beyond fixed income. As noted earlier, a structural increase in investor risk aversion – reinforced by the global crisis – has led to a persistently elevated equity risk premium (ERP). If this policy framework were effective at reducing the probability of a liquidity trap, nominal bond yields would tend to climb but underlying economic volatility may also decline – both of which would argue for a narrower ERP.