Marijn Bolhuis, Jakree Koosakul and Neil Shenai are economists at the International Monetary Fund. All views expressed are their own and do not reflect the views of the IMF, its Executive Board or its management.

Central banks have initiated the most aggressive and synchronized interest rate hike cycles in decades. At the same time, budget deficits and debt in industrialized countries continue to rise.

This has led many observers to point to the potential tensions between monetary and fiscal policies: the combination of restrictive monetary policy and high deficits is detrimental to financial sustainability, while loose fiscal policy can increase inflationary pressures and thus complicate monetary policy.

To better understand fiscal-monetary tensions, we recently introduced the concept of a “fiscal R-star.” No, no, please come back! We know there may be some R* fatigue, but we will try to explain why this variant is a useful concept.

I have a bad feeling about this

In short, the fiscal R-Star is the real interest rate that stabilizes a country’s debt ratio in the face of its deficit trajectory when output is at its potential and inflation is at its target.

If the fiscal R-Star is above the average interest rate on government debt, there is scope for fiscal policy to increase deficits. If it falls, this scope shrinks.

The fiscal R-star is similar to the R-star concept in monetary policy (and its financial R-star counterpart – the so-called “Dark Menace”). While the monetary R-star guides central banks’ interest rate policy to achieve inflation targets, the fiscal R-star can guide fiscal policy to ensure debt sustainability.

By basing our analysis on real interest rates, which influence both fiscal and monetary policy, we can analyze their relationship both theoretically and empirically.

Let us call the difference between the monetary R-Star and the fiscal R-Star the “fiscal-monetary gap,” which measures the tensions between fiscal and monetary policy.

You can derive the fiscal-monetary gap based on a standard macroeconomic framework using IS and Phillips curves and the law of motion of debt accumulation. For the math geeks, the fiscal-monetary gap can be expressed as follows, where a positive gap is associated with rising debt (first period), above-target inflation (second period), fiscal consolidation (third period), and term premium compression (fourth period).

When the monetary R-star and the fiscal R-star are equal, policymakers can simultaneously keep inflation at target and stabilize debt. However, when the monetary R-star exceeds the fiscal R-star, difficult policy trade-offs arise.

If, based on the above equation, the central bank sets its policy rate to match the monetary R-star, the dynamics of public debt could become explosive without any reduction in the deficit. Alternatively, the central bank could keep interest rates below the monetary R-star to “enable” deficit spending. This reduces debt accumulation but makes it more difficult to achieve price and financial stability.

Given these conflicting objectives, policymakers may be tempted to resort to financial repression and force domestic savers and financial institutions to take over government debt.

A major disruption of power

Our in-depth paper documents the evolution of fiscal-monetary tensions throughout modern history, based on 140 years of data from a group of advanced economies.

As you can probably imagine, fiscal-monetary tensions peaked during World War II. After reaching historic lows in the 1970s, the gap remained small and relatively constant from the early 1980s to the mid-2000s, largely due to the decline in the monetary R-star following the Volcker-era disinflation of the early 1980s.

The fiscal-monetary gap has been widening since the mid-2000s, and by the end of 2022, fiscal-monetary tensions are at their highest level since the 1950s.

So what happens when fiscal-monetary tensions are high?

In the past, larger fiscal-monetary gaps have been followed by rising debt levels, higher inflation, and weaker exchange rates (standard note: our empirical research helps to identify statistically significant relationships, but more work is clearly needed to explain the causal link more fully).

Larger gaps also correlate with so-called sovereign debt liquidation, the use of low real interest rates and surprise inflation to reduce the real value of debt. Not surprisingly, larger fiscal-monetary gaps tend to precede lower real returns on bonds and cash, raising the risk of future debt, inflation, currency, real estate and financial crises.

These are not the compromises you are looking for…

Given the increasing tensions between fiscal and monetary policy, what can we do to avoid these negative consequences?

Governments have an important role to play here. Provided that independent central banks can (and should!) continue to meet their inflation targets, conventional deficit reduction can increase the fiscal R-star and reduce fiscal-monetary tensions over time. Similarly, growth-enhancing reforms can increase potential growth and increase the fiscal R-star, which would also reduce tensions.

But implementing fiscal consolidation and structural reforms can be … challenging. Voters are not enthusiastic about higher taxes and lower government spending. They are often unwilling to accept short-term losses for long-term gains. Without a fiscal crisis, it is unlikely that governments will prioritize fiscal consolidation, given the significant spending needs.

Perhaps the monetary R-star will continue its long downward trend and ease tensions without major fiscal adjustments. But as Larry Summers and others argue, the future path of the monetary R-star is highly uncertain, so policymakers probably should not bet all their eggs in one basket on a return to long-term low interest rates.

Politicians may be tempted to liquidate large amounts of debt through various forms of financial repression or to pressure central banks to abandon their inflation targets and allow additional spending. However, this would have devastating consequences for savers and the independence of central banks.

Before choosing a life of higher fiscal and monetary stress, policymakers should consider the lessons of history and their implications for the present. A certain degree of prudence and humility is required in policymaking.

In some cases – as in the early stages of the pandemic – it is crucial that monetary and fiscal policy work hand in hand to support families and businesses. But when a gap opens between the real interest rate that is consistent with price stability and the real interest rate that stabilizes the government debt ratio, some give must be made. R-Star Star Wars is back.