Nobody knows exactly what the Fed is up to, and that includes the Fed itself. Of course inanimate institutions don’t know anything. What I really mean is that Ben Bernanke doesn’t know precisely what the Fed will do in the future. But there’s one thing that no one can deny—the Fed has set an explicit 2% inflation goal, and in recent years has frequently moved aggressively when inflation expectations seemed to be diverging sharply from that goal. Indeed it seems to me that the 2% inflation target is gradually becoming more credible, and hence I would not expect the 5 year TIPS spreads to diverge too far from 2%.
What does all this mean? Ryan Avent has a good post that discusses one implication:
The bottom line is quite simple, says CBO. If all of the fiscal blow is deflected, the economy should grow at an annual pace of 5.3% in the first half of the 2013 fiscal year. If Congress is unable to find a way to defer some of the impact, the economy will instead shrink by 1.3%.
. . .
Except, of course, that the economy will almost certainly not grow at a 5.3% rate no matter what Congress does. Arguments to the contrary are subject to what econ bloggers have come to call the Sumner Critique, after economist and blogger Scott Sumner. It is reasonable to assume, by this critique, that the Federal Reserve has a general path for unemployment and inflation in mind and it will react to correct any meaningful deviation from that path. A 5.3% growth rate is well outside the range of current Fed projections. Growth that rapid would almost certainly bring down unemployment quite quickly, triggering Fed nervousness over future inflation and prompting steps to tighten monetary policy. Growth might run slightly above Fed forecasts for a bit, but the overall fiscal effect will be dampened considerably.
I think this is right. But Ryan is less confident that the Fed would cushion the blow if we had a fiscal tightening in early 2013:
There can be quite a large lag between the onset of falling real output and a drop in inflation, especially (thanks to downward nominal rigidities) at low levels of inflation. If the Fed becomes less responsive than normal, the fiscal multiplier rises. Imagine a world in which the Fed waits to see how Congress behaves and then waits until the economic impact of Congress’ behaviour translates into falling inflation before stepping into action. Inflation may not depart from trend by all that much, but real output would likely dip substantially as a result of the fiscal cliff.
Ryan points out that it doesn’t have to be that way:
The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.
I think these are plausible arguments. But then he makes a very peculiar claim:
The Fed will almost certainly not do this.
Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy. The Fed would very much prefer that Congress behave—lay out a plan for medium-term fiscal consolidation but keep short-term cuts small and manageable. It is therefore in the Fed’s interest to imply that the fiscal cliff is a real economic danger, even if it could potentially prevent it from being one.
This is a very peculiar definition of “reckless” fiscal policy. The standard theory says the Fed should take a tough line on fiscal irresponsibility, and not help Congress out when they run up massive deficits. They should tell Congress they have no intention of monetizing the debt. The standard model says the most effective policy is to run small deficits, or even surpluses, and have the Fed do the demand stimulus required to keep aggregate demand on track. Ryan’s making precisely the opposite claim. He’s saying that if Congress does the right thing, and gets its fiscal house in order, then it’s in the Fed’s interest to punish Congress with tight money, so they don’t ever again do something so “reckless.”
Now I’m pretty sure that Ryan would claim I’ve mischaracterized his views. It seems his point isn’t that smaller deficits are a bad thing, but rather that Congress shouldn’t move so precipitously. And why not? Presumably because the Fed cannot or will not cushion the blow. I think they can, and my hunch is that Ryan agrees. So then it becomes “will not.” But here’s where things get really strange. In that case the Fed would be punishing Congress for not realizing just how irresponsible Fed policy really is. “If you do the policy that would be optimal conditional on us doing the right thing, we’ll punish you for having the audacity to assume we’ll do the right thing, by doing the wrong thing.” Or something like that. This is not to say that Ryan is wrong; just that it’s a strange argument, the more you think about it.
Update: Ryan Avent has a new post clarifying his argument.
Game theory isn’t my forte, so let’s talk about the supply-side, where things are a bit easier to pin down. In my view the fiscal cliff would slightly reduce aggregate supply. It might also reduce AD, but I think the Fed would mostly offset that effect. But aggregate supply is a different story. Even though the reduction in AS is likely to be small, under inflation targeting it would lead the Fed to reduce AD as well. So I think growth would slow modestly if there is a fiscal cliff. Say 1% to 2% RGDP growth in 2013, instead of 2% to 3% with no fiscal cliff. Inflation would be roughly 2% either way. That’s just a guess on my part, but then who’s got a model that’s included all the game theory I’ve been discussing? Have any of our elite macroeconomists figured out how to model the monetary/fiscal interaction? . . . Bueller?
PS. Some might argue that the British case undercuts my argument. But they have a less robust supply-side than the US, with inflation running consistently above target, even in the recession. It seems unlikely that the US could have both a demand-side recession and inflation running persistently above 2%. Note that I said “demand side recession,” I’m not disputing that a big oil shock could do the trick.
PPS. In a previous post I tried to cause trouble between Krugman and Yglesias. In a new post Matt gracefully avoids being snared in my trap:
When I wrote about this previously, I think I was too clever by half and just acted as if the Fed would in fact offset this all. Very possibly they won’t.My point is that if they don’t offset it, they’ve failed to do their jobs.
Even though he’s more pro-fiscal stimulus than I am, I love the way Ygleisas writes about this problem. So many people make excuses for the Fed (on both the left and the right.) They say it’s not easy for them to do their jobs. There is public criticism. True, but then again it’s not really all that hard, when you consider other jobs like fighting in Afghanistan. I expect our monetary policymakers to step up to the plate and do something dramatic for the millions of unemployed. Deep down in their guts they know we need more demand. We should insist on nothing less than the best from them.
PPPS. During football games when the other team has the ball 4th and 1 on our 40, I’ve always been quietly pleased when the other coach sent in the punter. This is odd, as the opposing coach should make a decision that makes me upset. Later I learned from the football equivalent of Bill James that most coaches blow this call, and you actually should go for it. (Or they used to blow it, perhaps it’s changing now.) I think the same is true of Bernanke. I’m pretty sure that over the past three years he’s quietly rooted for the NGDP numbers to come in above the Fed’s forecast. And that’s just not right.
HT: Bruce Bartlett