Central Banks Must Bridge the Gap Between Fiscal and Monetary Policy

Central banks have traditionally operated independently of government fiscal policies, but this separation is being questioned in light of recent market volatility.

In September 2022, the Bank of England was forced to intervene in the gilt market due to a budget-triggered crisis. This incident highlighted the cracks in the wall between monetary and fiscal policy, which has been based on the doctrine that independence is key to credibility.

This doctrine, which originated with Volcker's disinflation and the rise of inflation targeting, was designed to prevent governments from leaning on central banks for cheap financing. However, it does not account for situations where fiscal and monetary credibility move together, priced by the same investors in the same market at the same time.

The pattern is not unique to the UK or the euro area, with other countries such as the US also having a post-war construction of central bank independence.

Co-operation between fiscal and monetary authorities is now seen as necessary to address issues such as artificial intelligence-driven capital intensity, which risks widening the gap between productivity gains and wage growth. A new framework for co-operation would require pre-commitment, transparency, and a sunset clause to avoid capture mechanisms.