If the US goes off the fiscal cliff – that is, if tax
increases and spending cuts go into effect in 2013 as currently scheduled – can
monetary policy actions offset the macroeconomic impact? Ben Bernanke doesn’t think so – indeed he’s certain
they can’t – and he has said as much.
But on some level he must be wrong. True, it’s hard to think of any feasible
monetary policy action that would both be strong enough and have a sufficiently
quick impact to offset the fiscal cliff directly. But what matters more for monetary policy is
not the direct effect but the effect on expectations. Surely the Fed could alter expectations of
future monetary policy in such a way that the resulting increase in private
spending would be enough to offset the decreased spending due to fiscal
tightening. Just think, for example, if
the Fed were to increase its long-run inflation target. If nothing else, a sufficiently large
increase in long-run US inflation expectations would make the dollar sufficiently
unattractive to result in an export boom that would offset the fiscal
tightening. More important, perhaps, it
would make currency and Treasury securities less attractive to Americans and
encourage them to do other things with their wealth, such as buying houses and
durable goods and investing in productive capacity.
Of course that isn’t going to happen. To get the Fed to do something as drastic as
increasing its long-run inflation target, we’d need more than a fiscal cliff;
we’d probably need something like a repeat of the 1930’s. But at this point the Fed has substantial
amount of flexibility even within the confines of its long-run target, because
it hasn’t specified how that target would best be implemented. It hasn’t said, for example, whether the
target should be interpreted as a growth rate target – where policy constantly
begins with a clean slate, ignoring previous missed targets – or a level path
target – where policy always attempts to compensate for earlier misses and
regain the original target path. If the
latter case prevails, the Fed hasn’t said whether the target path would be
retroactive and if so how far back it would be retroactive (for example,
choosing 2007 as a base year for the target path instead of 2012). Moreover, while the Fed has affirmed its
commitment to its dual mandate, it hasn’t said how its inflation targeting
approach would interact with its employment mandate.
One way to implement the long-run inflation target would be
as follows. First, estimate the economy’s
potential output path that was, as of 2007, consistent with maximum
employment. Then add to this a 2%
inflation path starting from the 2007 price level. Express the result as a target path for
nominal GDP, and project that path into the future at the estimated future
growth rate of potential output plus 2%.
Pursue this path as a level path target.
Because nominal GDP has fallen so far below the path that
would, in 2007, have been consistent with 2% inflation at estimated potential
output, this approach implies a very dramatic period of catch-up. Essentially, the Fed would be committing to
follow a very aggressive pro-growth, pro-inflation policy over the medium run
as soon as it is able to get some traction on the economy. But it would be doing so in a way that is
consistent with its 2% long-run inflation target.
The effect on expectations would be quick and dramatic. By promising either growth or inflation or
both, the Fed would make hoarding cash (or other safe assets) look like a
clearly losing proposition. Depending on
whether you expect inflation or growth, either your money will lose its
purchasing power, or you will miss out on a lot of profits as real assets
recover. My guess is that, with this
change in the medium-run outlook, the resulting increase in private spending
over the short run would more than offset the fiscal cliff. Your guess may be different, but in any case we’re
talking about an impact considerably larger than what can be accomplished with
the kind of changes in its balance sheet that the Fed typically contemplates now
when it thinks about trying to stimulate the economy. If Ben Bernanke were contemplating anything
like what I am suggesting, he clearly wouldn’t be justified in being certain of
his inability to offset the fiscal cliff.
OK, this isn’t going to happen either. At least it’s highly unlikely. Ben Bernanke isn’t going to have his “Volcker
moment,” as Christina Romer called it, just in time to offset a huge tightening
in fiscal policy. And, with any luck,
the tightening in fiscal policy won’t be as huge as current law
prescribes: after the election,
hopefully, either one party will be in power, or Democrats and Republicans will
be able to come to enough of an agreement to prevent disaster.
But the sad thing is that preventing disaster almost
certainly means putting the US back on an unsustainable fiscal path – because
there’s very little chance that Congress will be able to agree on a credible
long-run fiscal plan at the same time that it agrees on a way to avoid going
over the cliff in the short run.
Assuming that we do go over the cliff and that the Fed doesn’t offset
the impact, the long-run fiscal results may not be much better, because the
growth impact of the fiscal shock – allowing for hysteresis effects – will undo
at least part of the improvement in the budget.
For those whose primary concern is fiscal sustainability, the best-case
scenario would be that we do go over the cliff and that the Fed acts
aggressively to offset the macroeconomic impact.
Again, it isn’t going to happen. And that’s kind of sad. The Fed’s timidity is creating a situation
where the only realistic choices – for the moment anyhow – are economic
disaster and fiscal irresponsibility.
Doesn’t that mean that the Fed bears some responsibility for the fiscal
problems that are eventually likely to emerge?
DISCLOSURE: Through my investment
and management role in a Treasury directional pooled investment vehicle and
through my role as Chief Economist at Atlantic Asset Management, which
generally manages fixed income portfolios for its clients, I have direct or
indirect interests in various fixed income instruments, which may be impacted
by the issues discussed herein. The views expressed herein are entirely my own
opinions and may not represent the views of Atlantic Asset Management. This
article should not be construed as investment advice, and is not an offer to
participate in any investment strategy or product.
