Monetary, Macroprudential and Fiscal Policy

Chapter 6 Monetary, Macroprudential and Fiscal Policy Júlia Király, B.Cs., L.J. and Katalin Mérő Abstract The chapter provides an overview of the conduct of fiscal, monetary and macroprudential policies in the Emerging European Economies since the Global Financial Crisis, including the policy response to Covid-19 and the post-pandemic challenges. We show that changes in the institutional frameworks both at the regional and national level led to a significant expansion of the instruments available for policymakers, as well as enhanced fiscal frameworks and resilience in the financial sector. At the same time, monetary policy was constrained by several factors, including the global financial cycle, the structural decline in interest rates and the globalization of inflation. The large policy accommodation in response to Covid-19, including through the use of unconventional tools, helped mitigate the economic damage. The post-pandemic challenges, however, are significant, given the limited policy space, some structural factors affecting inflation and interest rates, as well as potential threats to independent institutions. Júlia Király B International Business School, Budapest, e-mail: [email protected] Pending on employer’s authorisation Pending on employer’s authorisation Katalin Mérő Budapest Business School, Budapest, e-mail: [email protected] 1 2 Király et al. 6.1 Introduction Over the past decade, the conduct of macroeconomic policies in the Emerging European Economies (EEE) has been influenced by several factors, including the reform of both the national and regional institutional frameworks, significant shifts in the global economic landscape, as well as the need to respond to the major challenges arising from the Global Financial Crisis (GFC), the European sovereign debt crisis and the Covid-19 pandemic. The GFC and the European sovereign debt crisis reiterated the importance of re- ducing vulnerabilities and increasing resilience to external shocks, including through the revamp of fiscal governance frameworks, as well as the strengthening of financial sector supervision and regulation. For example, the reform of the European Union’s (EU) Stability and Growth Pact led to increased emphasis on public debt and stronger enforcement mechanisms while allowing for flexibility conditional on the economic cycle. In addition to and partly triggered by the EU-level changes, the national governance frameworks also evolved, including the establishment of independent fiscal institutions and the adoption of fiscal rules. Similarly, the macroprudential institutional framework was developed both at the EU- and national level, leading to the establishment of the European Systemic Risk Board and national authorities, as well as the widespread use of macroprudential tools across EEE countries. Monetary policy frameworks also underwent major changes in the aftermath of the GFC. Following Slovakia and Slovenia, the Baltic states also adopted the euro by the mid-2010s, while Bulgaria and Croatia – with both countries using the euro as an exchange rate anchor, albeit under different exchange rate regimes – entered the ERM-II during the Covid-19 pandemic. Although Czechia, Hungary, Poland and Romania maintained the inflation-targeting framework and the de jure floating exchange rate regime, the degree of exchange rate flexibility differed across countries and periods, reflecting the challenges arising from swings in capital flows, the limited monetary policy space, and the tolerance of the central bank towards exchange rate volatility. The conduct of macroeconomic policies has also been affected by the changing global economic landscape. For example, the decline in global interest rates on the back of structural factors such as demographic changes and low productivity growth reduced monetary policy space but enhanced the room for fiscal policy. Moreover, given the high degree of financial openness, the independence of monetary policy has been constrained by the emergence of the global financial cycle (Rey, 2015), with the latter largely influenced by monetary policy in major advanced economies in the aftermath of the GFC. Against the backdrop of increasing economic interconnected- ness, including through global value chains, the ‘globalization’ of inflation implies inflation becoming less responsive to domestic economic slack, thereby potentially increasing the trade-offs for monetary policymakers. Finally, the unprecedented na- ture of the Covid-19 crisis also necessitated largely accommodative fiscal, monetary and macroprudential policies, including through the use of unconventional measures. The post-GFC period also highlighted the importance of the interaction and coordination of policies. Specifically, the largely accommodative monetary policy 6 Monetary, Macroprudential and Fiscal Policy 3 increased fiscal space by lowering both the interest rate and the need for automatic stabilizers. In turn, sustainable fiscal policy could enhance monetary policy space by lowering the country risk premium. There has also been some empirical evidence that the use of macroprudential policies could increase monetary policy space when facing external shocks. Notwithstanding the benefits associated with the strengthened policy frameworks, the policy challenges will be significant in the aftermath of the Covid-19 pandemic. Given the largely accommodative policies in response to Covid-19, both fiscal and monetary policy space will be limited. The latter will also be affected by the impact on interest rates and inflation of structural factors that are beyond the scope of macroeconomic policies. The emergence of cryptocurrencies will imply further challenges for the conduct of monetary policy. Finally, the increased attention to monetary policy, including its distributional effects and potential role in climate change policies, could pose a threat to central bank independence. Therefore, clear communication about the mandate of central banks and the justification of the use of policy tools would be more important than ever in the past. In the remainder of the chapter, we provide an overview of the main developments between the GFC and the Covid-19 pandemic (Section 6.2), the response to the Covid-19 crisis (Section 6.3), and the post-pandemic policy challenges (Sec- tion 6.4). In doing so, we will cover the non-Baltic EEE countries, albeit to a different extent across macroeconomic policies, reflecting the differing degree of policy independence (e.g., lack of monetary policy independence in the members of the euro area). 6.2 Recovery and Progress After the Global Financial Crisis 6.2.1 Monetary Policy Over the past three decades, the monetary policy framework has been evolving rapidly in EEEs, reflecting economic challenges (with the use of exchange rate pegs as an anchor during the transition period followed by a shift towards more flexible regimes during the convergence period), the global spread of inflation targeting (IT) regimes and central bank independence, as well as developments in European integration (with two EEE countries adopting the euro before the 2010s). Based on the monetary policy framework, EEEs can be divided into three main groups a decade after the GFC: • Euro area members: Slovenia (2007), Slovakia (2009), • ERM-II members: Bulgaria and Croatia (July 2020), and • Inflation targeters: Czechia, Hungary, Poland and Romania. As Slovakia and Slovenia gave up independent monetary policy at the time of their accession to the euro area, while Bulgaria’s currency board arrangement limited 4 Király et al. monetary policy independence even before its entering the ERM-II, they are not subject to the analysis of monetary policy in this chapter.1 Nevertheless, they will be used as a control group when discussing the performance of the EEE countries in terms of inflation. In Croatia, the use of the euro as an exchange rate anchor constrains the independence of monetary policy and distinguishes the country from the inflation-targeting EEE countries in terms of the available policy tools, therefore its coverage differs from those of the inflation targeters in the remainder of the chapter. 6.2.1.1 Conventional and unconventional monetary policy tools2 Policy rate and corridor Most inflation-targeting EEEs entered the post-GFC decade with an ongoing easing cycle. Specifically, the collapse of Lehman in 2008 was followed by a series of policy rate cuts by each inflation-targeting EEE country to counterbalance the real economic crisis, with the notable exception of Hungary where a rate hike of 300 basis points was triggered by the significant depreciation pressure at the peak of the crisis (Figure 6.1). This, however, was quickly reversed as an improvement in investor sentiment, partly attributed to the IMF-EU-WB financial assistance program, reduced the country risk premium. In general, countries with high FX indebtedness (Poland, Hungary, Romania) were more cautious, given the potentially destabilizing impact of the weakening of the exchange rate. In 2011-12, the supply-side inflationary pressure arising from food and oil prices and the depreciation of the currency, with the latter driven by the contagion effect of the euro area crisis (combined with increasing concerns about policymaking and the rule of law in Hungary) forced Poland and Hungary to increase the policy rate, before returning to the easing cycle. During the mid-2010s, policy rates hit their pre-Covid historical minimum, reaching 0.5, 0.9, 1.5 and 1.75 percent in Czechia, Hungary, Poland, and Romania, respectively. The post-GFC

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