Fiscal Policy, Disinflation, and the Safety Net

The Issue:

The upsurge in inflation across the world since 2021 has been the sharpest in more than three decades. While inflation affects all people in an economy, its effects can be particularly harmful to poorer households. The standard approach to reducing inflation, by causing a recession through monetary tightening, can also disproportionately harm the poor. A recent study by the International Monetary Fund suggests that fiscal policy can help monetary policy curb inflation, while at the same time supporting poor families from the cost-of-living effects of inflation as well as from the contractionary effects of disinflation.

Smart fiscal policy can help restore price stability while lessening the impact of the cost-of-living crisis on poor families.

The Facts:

• Inflation has uneven effects across different income and age groups and often leads to a rise in poverty. The distributional effects of inflation work through three main channels. First, while inflation represents a rise in the overall national price level, there will be differences in the inflation rate across categories of goods which can adversely affect poorer groups. For example, lower-income families typically spend a higher proportion of their income on food and housing. Therefore, higher rates of inflation that include spikes in food prices typically represent more of a burden on lower-income households than on those which are richer. A second channel operates through inflation’s effect on incomes. Lower-income households may be disproportionately affected by overall inflation if their wages or, for retirees, pensions, do not have cost-of-living adjustments that keep up with inflation. A third channel is through the effect of inflation on the value of assets and liabilities held by households. While some asset prices adjust with inflation, especially if inflation is expected and the price of a fixed-income asset reflects this expectation, unanticipated inflation erodes the real value of assets, which can be a particular problem for older age groups who are often net lenders and hold fixed-income assets. At the same time, younger people, who are net borrowers, may benefit from the erosion of the real value of loans that they need to pay back.
• An analysis of the effects of the recent surge in inflation in six countries highlights the complexity of these redistributive effects. The IMF study involved surveys of thousands of households in Colombia, Finland, France, Kenya, Mexico, and Senegal. The surveys were conducted from mid-2021 to mid-2022 when inflation surged worldwide. The study finds that the negative impact of inflation on the cost of living, the first channel discussed above, was particularly sizable for lower-income groups in the less advanced economies since food purchases were a larger proportion of their overall spending. The income channel operated differently across these countries since energy prices rose more than other prices due to the disruptions from the war in Ukraine. Higher energy prices tended to benefit people in countries that exported oil (Colombia and Mexico) but reduced spending on non-energy goods and services in the other countries. The wealth channel was most important in the more advanced countries where there is more borrowing and lending because of better developed financial markets. In those countries, inflation eroded the real value of assets. Older families who were net lenders and therefore held assets tended to lose out because of inflation while younger families who were net borrowers benefited from a lower inflation-adjusted cost of the repayment of their debts. 
• Fiscal policy can contribute to lowering inflation both by directly reducing aggregate demand and by making the disinflationary policy package more credible. Inflation is typically fought through tightening monetary policy which raises interest rates and causes a recession that lowers price pressures. However, research suggests that fiscal policy — through bringing down the size of government deficits for instance — can be used in conjunction with monetary tightening to reduce aggregate demand and thus ease pressures on prices (see here and here). Moreover, policies are more effective, and come at a lower cost in lost output, if the policies are viewed by the public and financial markets as credible – that is, that the government will continue with the policies until the battle against inflation is won. Fiscal adjustment that is consistent with disinflation can help foster this credibility. 
• There is empirical evidence that reducing public spending helps to lower inflation. The recent IMF study finds that reducing public spending by one percentage point of GDP lowered inflation by 0.5 percentage points in a sample of 17 advanced countries starting in 1985 (see Chapter 2). The effects of fiscal policy were found to be larger pre-1985 when monetary policy was relatively passive.   
• Fiscal policy can also mitigate the unwelcome distributional costs of a disinflationary monetary policy that causes interest rates to spike. Central banks need to raise interest rates by substantially more to fight inflation when they act alone rather than in conjunction with fiscal policy (see here). This can particularly hurt the consumption of younger households, who do not hold interest bearing assets and may even have to repay debt at higher rates, at a time when they may also be hurting from a cost-of-living shock. Well-designed fiscal policy can help to alleviate such adverse effects. In particular, cuts in lower-priority government spending combined with targeted transfers to lower-income families that have the net effect of reducing aggregate demand can support disinflation while at the same time protecting the poor. This not only mitigates the adverse distributional effects of disinflation but also, in so doing, makes the maintenance of a disinflationary policy more credible and, therefore, more effective.