In today’s interview Ben Bernanke denied that Fed policy was enabling a reckless fiscal policy. He noted that the Fed’s mandate related to inflation and jobs, not telling Congress what to do with fiscal policy. He pointed out that a tighter monetary policy would make the deficit larger, and even more difficult to address.
I’ve always had a lot of sympathy for that argument. But a recent post by Andy Harless suggests that the same argument can be turned against the Fed:
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. . . .
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. . . .
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?
That’s right. And I think this also helps explain (to my critics) why I tend to favor a more stimulative monetary policy. If I didn’t think monetary policy was excessively contractionary, then I’d have absolutely no concern about the fiscal cliff. I’d simply assume the Fed would cut rates to offset the impact. This was Paul Krugman’s assumption when he called for the Bush administration to tighten fiscal policy. And Krugman was right.
But I do have concern about the fiscal cliff (and the slowdown in growth in other countries.) The fact that I am concerned, whereas during 1983-2007 I never once had this sort of concern, tells me that I instinctively worry that money is still too tight. My hunch is that most other economists also worry that the fiscal cliff might lead to a double dip recession, which I take as meaning that they think NGDP growth is too slow.
Under current Fed policy we have an NGDP growth track that is not considered strong enough to prevent a recession if we got hit by a severe adverse shock. That means we are on the wrong track. And because the Fed is too tight, fiscal deficits are too large. Stop asking if the Fed is enabling an excessively stimulative fiscal policy by being too easy, and start asking whether the Fed is forcing Congress to run up excessive deficits because NGDP isn’t growing fast enough. And if they are, doesn’t that mean money is too tight?
PS. Matt O’Brien has an excellent piece on Bernanke in The Atlantic