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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is director of the National Institute of Economic and Social Research
The current monetary-fiscal framework for big economies was devised for a world of low inflation, small central bank balance sheets and modest public debt.
Fiscal policy would seek to keep debt on a sustainable path and engineer an appropriate distribution of income. Monetary policy, delegated to independent central banks, would seek to deliver stable nominal demand and low inflation.
In that era, co-ordination was barely needed. Each arm of policy had a distinct mandate, and spillovers between them were small. Where they did occur, monetary policy could adjust to the fiscal stance, raising or lowering the policy rate as needed.
This is no longer the world we live in. Public debt has reached its highest level in more than half a century, inflation volatility has returned with a vengeance, and central bank balance sheets have ballooned.
Spillovers between fiscal and monetary policy are now large and unavoidable. Today, most of the spillovers run from monetary to fiscal. Rate hikes raise debt-servicing costs and, in the UK, trigger indemnities that require governments to cover central bank losses. Quantitative tightening — the reversal of massive asset buying programmes to support the economy and markets — compounds these spillovers, both by realising losses for the Treasury and by pushing up gilt yields, This tightens the fiscal constraint still further.
Pre-Covid, the arrows ran the other way. Monetary policy was overburdened and constrained by limits to effectiveness when rates are near zero. Fiscal policy leaned towards austerity, making it harder for central banks to achieve their inflation objectives. We may have relied too heavily on central bank quantitative easing to boost aggregate demand as a result. As former Bank of England governor Mervyn King once quipped, “if central banks are the only game in town, I’m getting out of town”.
Debt financing choices mattered too. QE works in part by removing the duration risk of holding debt for longer periods of time from private-sector balance sheets — in effect replacing long-term government bonds with bank reserves. Governments responded by issuing at longer maturities, partly offsetting QE’s intended effect.
We need a workable regime to manage such issues. The principles should be threefold: first, make technical changes that reduce unnecessary spillovers; second, adjust when one arm of policy is at a binding constraint; and third, over time, move the system towards a state where spillovers are smaller — through stronger buffers and ultimately a reduction in the public debt-to-GDP ratio. Here are some practical steps we can make in the near term.
First, in the UK, we should reform the accounting treatment of Bank of England losses so that central bank losses do not trigger immediate transfers from the Treasury. The US model offers a sensible template: when the Fed incurs losses, it records them as a deferred asset to be offset against future profits, rather than drawing funds from the Treasury. This approach maintains transparency without forcing fiscal tightening that exacerbates a cyclical economic downturn. This would guard against the risk of interest rates being set with one eye on short-term fiscal impacts rather than the inflation target.
Second, we should pause active QT when fiscal headroom is minimal, to avoid amplifying stress by pushing gilt yields higher at precisely the wrong time. The combined effect of these changes would be to relax the constraint on fiscal policy. There is, of course, a respectable argument that these spillovers are a feature, not a bug: by tightening fiscal space, they impose discipline on government borrowing. The quid pro quo for easing that constraint must therefore be a renewed fiscal commitment to rebuild buffers and to bring down the public-debt ratio over time.
These arrangements could be codified in a formalised Treasury-BoE protocol, echoing earlier settlements such as the 1951 Fed-Treasury Accord or the UK’s 1997 reforms. Each marked a moment when economic realities forced a new balance between co-ordination and independence. The same is now required for a world of high debt and large balance sheets.
Together, these measures would help to diffuse current tensions between fiscal and monetary policy. By reducing areas of conflict, they may also help preserve central bank independence, at least in the short to medium term. But with debt-to-GDP at record highs, the longer-term challenge remains: without tackling that, the drift towards a situation where fiscal pressures dictate monetary policy — and with it, higher inflation — will be hard to resist.
