The need to now think about central banks’ strategies

One may have the impression today that central banks are at an impasse: they have let inflation become high without reacting; if they now really wanted to combat it, interest rates would have to rise so high that they would plunge economies into recession, especially as debt ratios are very high. But stamping out inflation as soon as it appeared would have required a highly restrictive monetary policy as early as 2021, which was inconceivable so soon after the COVID crisis and at a time when governments needed to finance huge fiscal deficits. The trap is clear: fiscal dominance forces central banks to facilitate the financing of fiscal deficits, but it prevents them from controlling inflation, leading either to the need for an even more restrictive monetary policy later if inflation is finally to be combated , or to the prospect of an inflationary spiral. The following strategy would be the only way to avoid this trap: as long as there is no inflation, monetary policies can actually help finance high fiscal deficits if those deficits are needed . B ut if there is an inflationary risk and high government spending is helpful, then taxes must be increased to curb demand instead of having to raise interest rates sharply, thus avoiding hurting investment , which must remain high . This approach would also be less dangerous for growth and financial stability than raising interest rates in an economy with very high debt ratios.