The shadow of monetary policy and the monetization of the deficit, as a reminder

A new paper by the International Monetary Fund, published in August 2026 by Jácome, Magud, Pienknagura and Uribe, brings a conclusion that deserves attention also for Albania. The study shows that the history of deficit monetization does not completely disappear with a change in the economic regime or with the strengthening of institutions. It may remain present as a kind of “institutional memory,” which affects the way central banks respond to the risk of inflation and, above all, to any sign that inflation expectations may become unanchored.

In countries that have gone through periods of monetary financing of the deficit, particularly where this process has been accompanied by populist policies and strong pressures on the central bank, the monetary authority tends to react more quickly and more forcefully when signs of rising inflation expectations emerge. This does not happen only because past inflation has been high. The reason is deeper: the central bank must continuously demonstrate that it is independent from the government’s fiscal needs and that the objective of price stability cannot be negotiated.

This conclusion is particularly important for Albania, not because the country is currently in a situation of deficit monetization, but because the history of the relationship between public finances, the central bank and inflation has left a legacy that cannot be considered entirely overcome.

Albania today

Albania’s monetary framework is much more consolidated than that of the beginning of the transition. The Bank of Albania operates under an inflation-targeting regime with a medium-term target of 3%. The policy rate is 2.50%, while inflation during the beginning of 2026 has remained around 2.4–2.5%, i.e. somewhat below the target. The dynamics have been influenced by the stabilization of food prices, the strengthening of the lek and developments in international commodity markets.

At the same time, new shocks from energy and oil prices may create temporary pressures on inflation. The Bank of Albania expects these pressures to be gradually absorbed and inflation to return toward the target during the year.

At first glance, this is a normal situation for a central bank operating under a consolidated inflation-targeting regime. But this is precisely where the IMF analysis becomes more interesting. The analysis goes further than the discussion of whether inflation is currently close to 3%. The more important issue is whether inflation expectations remain anchored and whether the public believes that the central bank will act without being constrained by the needs of public finances.

This shifts attention from the current interest rate to the institutional credibility that stands behind it.

The memory of difficult years

Albania has not had the same long history of fiscal populism and deficit monetization experienced by some European countries. The comparison should be made carefully. Nevertheless, during the early years of the transition, the Albanian economy went through periods of severe institutional weakness, fiscal dominance and high inflation, when the boundaries between monetary policy and the state’s financing needs were much weaker than today.

These experiences matter not only as economic history. They influence institutional culture and the way the risk of inflation is perceived. A central bank that has previously faced strong fiscal pressures has more reason to be cautious about any development that could be interpreted as a return of fiscal dominance.

Therefore, if inflation expectations begin to rise due to a combination of strong increases in public-sector wages, pensions, defense spending, large public investments or other expansionary policies, the monetary response may need to come earlier. Not necessarily because these policies are wrong in themselves, but because what matters is how they are financed and their impact on aggregate demand and expectations.

At this point, fiscal policy and monetary policy cannot be viewed as two separate policies. They are part of the same macroeconomic stability mechanism.

The risk is not only the deficit

For Albania, the main risk does not simply lie in a higher deficit in a given year. The risk actually arises when a sustained increase in public spending is not accompanied by sustainable sources of revenue and when the Albanian market begins to believe that monetary policy may be used, directly or indirectly, to ease the burden of public financing.

Increases in pensions and wages, capital investments, the expansion of defense spending and other budgetary needs may be economically or socially justified. But the problem arises when these commitments become permanent, while the financing sources remain temporary or uncertain.

The same logic applies to fiscal amnesty and other extraordinary measures. A policy that weakens the discipline of public revenues today may create a greater financial burden tomorrow. If the market perceives that the government increasingly needs accommodative monetary conditions, the independence of the central bank comes under pressure even without a formal request for deficit monetization.

This is why fiscal discipline is, in itself, an instrument for protecting monetary independence.

The Bank of Albania must protect credibility, not only the interest rate

In an economy with well-anchored expectations, the central bank does not need to react to every temporary movement in prices. But when expectations begin to change, the cost of a delayed response increases significantly.

Precisely for this reason, the communication of the Bank of Albania is of particular importance. The public, businesses and markets need to understand not only the decision on the policy rate, but also the logic behind it. If inflation moves away from the target, it must be clear which developments are considered transitory and which may trigger a monetary response.

Such communication makes monetary policy more effective. When expectations are anchored, the central bank can respond gradually. When expectations become unanchored, it is forced to use higher interest rates and maintain a tighter policy for a longer period.

Thus, credibility is economic capital. The greater this capital, the lower the cost of stabilizing inflation.

Fiscal policy should help, not test the central bank

From this perspective, the main objective of fiscal policy should not simply be formal compliance with a deficit limit. More important is for the structure of public finances to be credible and sustainable over time.

A stable primary balance, or at least a fiscal position that does not create persistent pressures on demand, reduces the need for monetary policy to maintain interest rates higher than would be necessary under normal conditions.

This is particularly important in an economy such as Albania, where the structure of the financial market and the depth of the capital market are still more limited than in developed economies. An expansionary fiscal policy may be transmitted more quickly into domestic demand, the exchange rate and price expectations.

In this sense, fiscal discipline is not a constraint on economic growth. It is a condition for more sustainable growth, because it gives the central bank more room to support the economy when conditions require monetary easing.

The limits of state financing must remain unquestionable

Another important lesson concerns the boundaries between public financing and monetary policy. Direct financing of the government by the central bank is today much more restricted by the legal and institutional framework. But the credibility of this boundary depends not only on the formal prohibition.

Even indirect forms of intervention require transparency and discipline. Purchases of government securities in the secondary market, exceptional use of the central bank’s balance sheet or the way profits are transferred should remain within a framework that does not create the perception that the central bank is being used to finance fiscal needs.

In a country with a difficult monetary history, perception can be just as important as the formal mechanism. Any weakening of institutional boundaries may bring back to the market’s memory the risk of fiscal dominance.

Expectations are the signal that must be heard earlier

One of the most important lessons of the IMF analysis is the importance of inflation expectations. Measured inflation today shows what has happened. Expectations show what economic agents believe will happen.

If businesses begin raising prices in advance, workers demand wage increases anticipating higher inflation, and contracts begin to be indexed more extensively, the process may become self-reinforcing. At this point, the central bank is no longer fighting only an external price shock, but a change in the behavior of the economy.

For this reason, monitoring expectations should be just as important as monitoring current inflation. Particular attention is required in sectors where prices tend to adjust more slowly, especially services and rents, because there demand pressures may appear more clearly and be more persistent.

The lesson for Albania

Albania is not today an economy characterized by deficit monetization. On the contrary, monetary and fiscal institutions are much more consolidated than in the first decades of transition. But this does not mean that history has become irrelevant.

The opposite is true. The more an institution is consolidated, the more important it becomes to maintain the trust it has built.

The message of the IMF paper for Albania is not that the Bank of Albania should tighten monetary policy more. The message is that it should maintain its credibility at all costs, while fiscal policy should avoid creating situations where the central bank is forced to choose between price stability and easing public finance pressures.

If fiscal discipline is maintained, expectations remain anchored, and the institutional boundaries between the government and the central bank remain clear, Albania can benefit from a more gradual and less costly monetary policy for the economy.

Conversely, if fiscal pressures increase without a stable source of financing, the cost will not necessarily appear immediately through monetary financing of the deficit. It may appear later and more costlyly: in higher interest rates, more expensive loans, weaker investment, and a slower pace of economic growth.

Ultimately, price stability is not only defended at meetings of the Supervisory Council of the Bank of Albania. It is built every day through the way the government collects revenues, spends public money, manages debt, and how credible economic policy is overall.

Monetary history does not necessarily repeat itself. But it leaves a shadow. And a responsible economic policy must recognize that shadow before it becomes a problem again.