When central bank losses undermine price stability
Do central-bank losses cause inflation and under what conditions do concerns about the central bank’s financial position weaken its commitment to price stability?
This is the question Anna Grodecka-Messi, Martin Kliem, and Gernot J. Müller are analyzing in this paper. The authors combine two approaches:
- Theoretical model: A New Keynesian framework separates the central bank’s balance sheet from the government’s and examines monetary policy when losses are not automatically covered by the treasury.
- Historical evidence: A newly constructed Riksbank dataset spans 1668–2023; archival research identifies ten adverse profitability shocks considered unrelated to systematic monetary policy, and local projections trace their effects on inflation, interest rates, and money growth.
They also compare monetary regimes and test whether low central-bank equity amplifies the inflationary effects of import-price increases.
Findings
- Profitability shocks raise inflation persistently, accompanied by lower interest rates and faster money growth, under fiat regimes, but not under metallic standards, where convertibility constrained monetary accommodation.
- Low equity amplifies supply-driven inflation: Adverse import-price shocks generate more inflation and a more accommodative policy response when the Riksbank’s financial position is weak.
- Losses are not inherently inflationary: In the model, the mechanism requires both absent fiscal support and a central bank that adjusts policy to protect its net worth.
The evidence identifies a potential risk for modern central banking, not proof that recent QE-related losses caused monetary accommodation.
Central Bank Losses and Inflation: 350 Years of Evidence
Authors: Anna Grodecka-Messi, Martin Kliem, Gernot J. Müller
From: Sveriges Riksbank, Deutsche Bundesbank, University of Tübingen
When public debt limits the fight against inflation
Can high public debt weaken a central bank’s response to inflation, even when the government remains committed to repaying its debt?
This is the question Hanno Kase, Leonardo Melosi, Sebastian Rast, and Matthias Rottner analyze in this paper. The authors develop a nonlinear New Keynesian model with sticky prices, a central bank that responds to inflation and output, and a government that adjusts its primary surplus to stabilize debt.
Their key addition is a ceiling on the debt-to-GDP ratio, representing a fiscal limit rather than a statutory borrowing cap. They assume that the central bank moderates tightening when necessary to respect this limit, capturing its desire to avoid fiscal or political pressure. Through the government budget constraint, the debt ceiling therefore becomes an upper bound on the policy rate that varies with debt, inflation, growth, and the primary balance.
The model is calibrated using postwar US data and existing research, then solved using global numerical methods to capture situations in which the constraint switches between binding and nonbinding. The authors simulate supply and demand shocks and compare outcomes with and without the fiscal constraint.
Findings
- Adverse supply shocks are particularly problematic. They raise inflation while weakening output, creating a need for monetary tightening precisely when public finances are under strain. The constraint produces less initial tightening and more persistent inflation than in the unconstrained model.
- Expectations matter before the constraint binds. Anticipating future accommodation raises current inflation: the baseline calibration produces a steady-state inflation rate of about 2.1%, against a 2% target, while a slightly tighter fiscal limit increases this bias to almost 0.4 percentage points.
- The type of shock matters. A demand expansion initially improves fiscal space through higher output, inflation, and tax revenues, whereas a downturn erodes it.
- Countercyclical fiscal policy creates a trade-off. Supporting activity during downturns can also increase borrowing needs and make the fiscal constraint more restrictive.
Distinctive contribution and caveat
Unlike the standard fiscal-theory explanation, inflation here does not arise because debt lacks fiscal backing, instead, it arises because protecting fiscal space weakens monetary tightening. The central bank can still raise real interest rates against inflation, but less forcefully than its unconstrained rule prescribes.
The perils of narrowing fiscal spaces
Authors:Hanno Kase, Leonardo Melosi, Sebastian Rast, Matthias Rottner
From: European Central Bank, European University Institute, De Nederlandsche Bank, Bank for International Settlements
