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Delroy Hunter Ministry of Finance could exacerbate BOJ’s interest rate dilemma

In the global fight against inflation, the world has focused attention on the actions of central banks that have led the charge by sharply increasing interest rates in many countries. However, in any given country, the success of the fight against inflation will not be determined solely by the actions of the central bank.

This is because central banks are tasked solely with crafting and effectuating monetary policy, which, in essence, controls money supply and influences the interest rates at which money can be borrowed.

As was made clear by Professor Goldberg in a July 29, 2022 article published in the Financial Gleaner titled ‘Rate Hikes Alone Won’t Curb Inflation’, there are several factors influencing inflation that are outside of the remit of central banks. Among these factors, supply chain constraints pose the greatest challenge to Jamaica’s fight against inflation because the economy is highly dependent on imports, and the prices of some may remain elevated for an extended period.

In an article in the Financial Gleaner on July 8, I supported the tight monetary policy stance adopted by the Bank of Jamaica, BOJ, in response to the spike in inflation, even if it stokes fears of tipping the economy into recession. I further stated that the BOJ could avoid crash-landing the economy. A month later, this seems distinctly possible as there are signs that inflation might have peaked in the United States, and there is an encouraging reduction in global oil price, although there is fear of a reversal in the winter when the demand for heating oil rises in Europe.

What if global inflation does not abate?

Notwithstanding the early signs of inflation abating, what happens if it does not? How high would the BOJ be willing to raise interest rate in its fight against inflation? The answer to these questions are complicated by the fact that there is an entity whose actions can aid or frustrate the efforts of the BOJ to fight inflation. This is the Ministry of Finance — the gatekeeper to the government coffers.

The MOF sets fiscal policy, which is concerned with government revenue – primarily taxation – and expenditure.

Simultaneously with the BOJ tightening monetary policy to control inflation, the MOF may induce inflationary pressures by using fiscal policy to stimulate the economy out of, or prevent, a recession. This could be achieved, for instance, by deficit financing — borrowing to spend more than it receives in taxes.

It is commendable that Jamaica has an independent central bank, allowing it to bring a long-term and virtually apolitical perspective to bear on the monetary policy management of the economy. Elected politicians in charge of fiscal policy, in contrast, might not take such a long view given the exigencies of elections and the tendency for voters to ‘blame the government’, even for actions that are within the purview of the independent central bank. So, while we maintain our focus on monetary policy, it should be borne in mind that the MOF executes fiscal policy and its actions can confound, or complement, BOJ’s tight monetary policy posture.

In fact, this is currently a debate in the United States, given that the Democrats successfully passed the CHIPS and Science Act, and have circumvented the gridlock in the Senate with the Inflation Reduction Act. These bills can lower inflation by reducing medical costs; extracting more taxes that would otherwise boost the wealth effect and, thereby, increase the demand for goods and services; reduce the deficit and, hence, diminish the scale of deficit financing; and improve future supply of certain products, for example, chips.

Other than the above direct effects, the bills should also lower expected future inflation, which also reinforces the decline in current inflation — much like I explained in the July 8 article for the scenario of higher expected future inflation. Nonetheless, while these aspects of the bills enhance the probability of reining in inflation, there is no denying that the bills will inject a substantial amount of spending power into the economy and could increase demand and frustrate the efforts of the United States Federal Reserve to lower inflation.

It would be reasonable to assume that the Government of Jamaica/MOF is contemplating a fiscal policy package to boost the economy and counter an anticipated decline in interest-sensitive private-sector investment should the BOJ find it necessary to maintain tight monetary policy for much longer. Surely, there are some such interest-sensitive investments; otherwise, what would have been the point of the pushback from the private sector against the inflation-fighting rate hikes?

As for a signal that the Jamaican government does not intend to let the economy slip too much, note the number of infrastructure projects that have been announced and/or initiated recently.

Although the government gives free rein to the BOJ to manage monetary policy, it does not imply that the government wants, or will allow, tighter monetary policy to affect all economic activities equally. For instance, while it is desirable that tighter monetary policy discourages civil servants from using their expected salary increase to borrow and upgrade from their high-efficiency cars to gas-guzzling SUVs, with implications for demand-driven inflation, the government would like to encourage local farmers to expand their economic activity and increase food supply. Because the latter would bolster the effort to control inflation, it might encourage the government to provide incentives to farmers.

But governments should not be capricious in executing fiscal policy, even in the special circumstances in which we find ourselves. That is, out of concern that the inflation fight by central banks could tip the economy into a recession, governments may be inclined to embark on unsustainable, debt-financed spending sprees, engage in short-term tax-and-spend policies, or might even alter tax policy in favour of specific sectors.

In these circumstances, the increase in fiscal policy uncertainty and the concomitant decline in credibility pertaining to any pledge to maintain a sustainable fiscal path might not only thwart central banks’ efforts to fight inflation, but may also precipitate a multitude of unintended consequences.

That the two main political parties in Jamaica have reached consensus on the need to exercise fiscal discipline to achieve fiscal stability, as recently highlighted by a former and the current prime minister, is worthy of celebration in this the 60th year of Independence.

When countries exercise poor fiscal judgements and, consequently, experience large and volatile fiscal deficits, high debt, and uncertain tax policy, they tend to face various negative consequences. Academic research shows that these consequences include higher inflation, slower economic growth, less innovation, reduced private-sector investment, elevated stock market risk, larger cost of capital for local firms, higher interest rates on sovereign debt, and a weaker domestic currency.

Jamaica should be able to avoid the more deleterious of these consequences, not only because there is now an established commonality of preference for fiscal stability, but also because the actions of the MOF are informed by a Fiscal Responsibility Framework and they have committed to establishing a fiscal council. These will improve the fiscal-monetary policy coordination between the MOF and the BOJ, and should aid both in achieving their respective goal of fiscally and responsibly avoiding a recession and controlling inflation.

Delroy M. Hunter, PhD, is the Serge Bonanni Professor of International Finance at the University of South Florida.

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