It is a mistake to suppose that central banks have the tools to alleviate the adverse consequences of poor fiscal policy, much less to restrain profligate governments. The most that the central bank can do is to reassure financial markets temporarily, until the government is able to implement a fiscal strategy which the markets find to be credible.
What that strategy turns out to be is specific to the circumstances of each case and cannot be known in advance. The fiscal authorities must discover it by a process of policy initiatives, followed by assessment of the effects of their actions and prompt course correction, until such time as interest and exchange rates settle down to some predictable pathway.
There is little chance of a return to financial market tranquility if fiscal and monetary policies are not closely aligned at every step. The process of policy-making in general, and most especially in times of difficulty, is best exemplified by circumstances of US President Richard Nixon’s announcement on August 15 1971, that the Federal Reserve Bank of New York would no longer sell gold at the fixed price of $35 an ounce.
In his revealing book Three Days at Camp David, Jeffrey Garten describes how that decision was taken. It was the outcome of intense discussion involving top officials from the US Treasury, the Federal Reserve and other economic officials and advisers. The discussions were informed by background studies which had been prepared beforehand and discussed with experts.
The president’s announcement was followed immediately by intense rounds of consultation with officials and leaders of business and opinion at home and abroad, explaining the reasons for the decision and responding to questions, comments and reactions. This led to a fully informed, consistent framework, based on the Camp David discussions.
Contrary to popular notions of central bank independence and monetary targeting of inflation, the most effective way to conduct economic policy is through a coordinated framework. Strategies should be formulated based on data and analysis by a council headed by the minister of finance and including senior economic policy expertise from the central bank and the Treasury. The council’s mandate should include joint formulation of government budgeting, financial and debt strategies, and monetary and exchange rate policies.
Targets for growth, inflation, public sector borrowing, debt management, exchange rates and interest rates should all be set within an internally consistent framework. It may not be advisable to announce all or any of the targets; what matters is that the public and the financial markets believe any announcements to be credible.
Policy changes should be announced simultaneously by the bank and the Treasury; the policy council should meet regularly to evaluate the most up-to-date information on the effects of policy and make course corrections as necessary. The council and its members should explain the strategy to the media and the general public, publish supporting data and analysis for those who wish to make their own evaluation and issue regular updates on progress with the implementation of the strategy.
There are many cogent reasons for joint policy-making by the Treasury and the central bank, including uncertainties about the credit channel, the spillover effects of monetary expansion to other economies, unwanted exchange rate movements, the effects of fiscal dominance on interest rates and macroprudential concerns.
But the most compelling argument against the notion of inflation targeting by an independent central bank is the loss of credibility by both the bank and the Treasury should the messages and signals emanating from those two sources not be the same. A framework for joint policy making is the only way to minimise uncertainty in financial and exchange markets, and to reassure those markets in times of difficulty that the authorities – monetary and fiscal – have control and are able to restore calm.
DeLisle Worrell is the author of Development and Stabilization in Small Open Economies, published by Routledge in January 2023. He was Governor of the Central Bank of Barbados from 2009-17 and is currently a member of the Bermuda Financial Policy Council.