Inflation targeting under fiscal fragility

Abstract

Indebted policymakers have a limited budget and are subject to inflationary shocks forcing them to either (i) increase interest rate to have inflation on the pre-announced target or (ii) accept higher inflation. We model the inter-temporal trade-off between fiscal and monetary policy when forward-looking, rational, and fully informed agents finance public deficits. We show that a high public-debt level opens the doors to adverse expectations, pressuring nominal interest rates and leading to target-coordination failure. Our parsimonious model with a single confidence shock supports the policy actions observed in the aftermath of the 2002 Brazilian crisis characterised by inflation expectations overshooting the target. First, a higher target level to restore coordination. Second, both a gradual reduction of debt-to-GDP, to improve fiscal strength, and an increase of the share of the public debt with pre-fixed interest rates as opposed to indexed debt. Finally, we find empirical evidence of higher debt levels and lower inflation targets increasing both the probability to overshoot the inflation target and increasing the size of the deviation from the target.