The monetary and fiscal policy responses to the COVID-19 pandemic set the stage for the inflation we are currently experiencing.

In the debate about what drives inflation and who is to blame, one important element has not received the attention it deserves: the coordination between monetary and fiscal policy.

Since Eric Leeper’s work in the early 90’s, we know that the combination between active (forward-looking) and passive (backward-looking) fiscal and monetary policy matters for the price level and inflation.

In his model, if fiscal policy is active and monetary policy is passive, deficits will increase inflation. Fiscal policy dominates monetary policy, and the central bank will have to adjust policies such to fulfil the constraints imposed by the demand for government bonds. Intuitively, fiscal policy does not adjust taxes (or spending) and the central bank must adjust the money stock to respond to deficits.

Recall that in New Zealand the increase in government spending since 2020 was mainly financed via the Large-Scale Asset Purchase (LSAP) programme (about $50b), which increased broad money by 21 percent: active fiscal and passive monetary policy.

One of the key mistakes was to ignore the importance of the coordination between monetary and fiscal policy. Monetary policy was too accommodative for too long, given the large debt-financed fiscal spending programmes that were issued without a strategy on how this debt will be repaid in the future.

Public statements by the Finance Minister, Governor Orr, and the MPC suggest that the importance of this coordination is still not fully understood.

The recent literature on the still debated fiscal theory of the price level (FTPL), which started with Leeper’s work, is very important for the RBNZ and the Treasury going forward.

This theory states that monetary and fiscal policies are bound together by a common budget constraint and that coordination – to some degree – is needed.

Any difference between the real value of government debt and the present value of surpluses generates changes in the price level (i.e inflation) that leads the economy back to equilibrium (by changing the value of nominal debt).

The inflation we experience is therefore, amongst other factors, driven by the lack of coordination between monetary and fiscal policy and has its root in the debt-financed fiscal expansion since 2020, which occurred without discussing how debt will be repaid.

Without changes in fiscal policy, reducing inflation purely by monetary policy means will be extremely painful.