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The Covid-19 pandemic casts the interaction between fiscal and monetary policy in a new light. The sudden and sizeable pandemic-induced recession has made greater demands on both fiscal and monetary policy, triggering the need for closer domestic policy co-ordination, and has led to a greater use of central bank balance sheets. The near-term macroeconomic challenges will likely persist, with growth expected to remain subdued even if the inflation outlook is more diverse across jurisdictions.
Going forward, a number of challenges loom large for the fiscal-monetary policy interaction in emerging market economies (EMEs). Although the inflation outlook is diverse across jurisdictions, monetary policy is expected to remain accommodative. Credibility issues and constraints on external funding are likely to limit fiscal policy space to a greater extent than in advanced economies (AEs). This can have adverse implications for financial conditions and growth. In some EMEs, large fiscal deficits, should they persist, could undermine price and financial stability. Much higher levels of public sector debt, coupled with political economy constraints, may complicate the conduct of monetary policy and the interaction between the two policies will be challenging, especially given the need to eventually raise interest rates and exit from balance sheet policies.
The note discusses these issues, drawing on evidence from a survey of EME central banks conducted for the meeting. It is organised in three sections. The first section reviews the interaction between monetary and fiscal policy during the first phase of the Covid-19. The second explores the main factors that enabled EME’s to respond in a strongly countercyclical way to this shock. The third focuses on mediumterm policy challenges during the period when high private and public sector debt levels will need to gradually decline and buffers to be built up as the economy returns to normality.
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