One Rate, Two Problems

The tension between monetary and fiscal policy is usually described in complex terms. In reality, however, it is a relatively simple issue. The government has a certain amount of debt, and this debt can only be kept under control in the long term if the cost of servicing it is not too high relative to economic growth, inflation, and the state of public budgets. In other words: there is an interest rate at which the debt-to-GDP ratio does not worsen. This threshold can be called the fiscal neutral rate (fiscal r* in technical terminology).

However, there is also another “correct” interest rate that is of interest to the central bank (monetary r*). This is not primarily determined by government debt, but by whether inflation is on target and whether the economy is growing neither too fast nor too slow. If prices and economic output are in equilibrium, the interest rate should also correspond to this equilibrium. And this is precisely where a problem can arise.

In the Czech context, to put it simply, the rate compatible with public debt stability appears to be lower than the rate compatible with price stability. This means that what would help the government service its debt may not necessarily be good for keeping inflation under control. Conversely, what is right from the central bank’s perspective may increase pressure on public finances.

If the central bank kept rates too low, it could provide short-term relief to the government. However, this would simultaneously increase the risk of higher inflation. Conversely, if it keeps rates where they should be from the perspective of price stability, the government’s debt servicing costs will gradually rise. This is not an immediate collapse, but without a change in fiscal policy, the debt could end up on an unsustainable trajectory.

The main conclusion is therefore quite straightforward: if fiscal policy is too loose, monetary policy alone cannot solve the problem. The central bank can either support public finances at the cost of higher inflation, or defend price stability and thereby expose the weaknesses of fiscal policy. In principle, it is simple: one cannot pursue two goals with a single tool; in addition to interest rates, it is necessary to work with fiscal policy as well.