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NRO’s domestic-policy blog, by Reihan Salam.

Ramesh Ponnuru and David Beckworth on the Fed and the Fiscal Cliff



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Ramesh Ponnuru and David Beckworth argue that while going over the fiscal cliff will have downsides, the concern that doing so will cause an immediate and deep economic contraction is overwrought, provided the Fed acts appropriately:

Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.

It could counteract the effects of the fiscal cliff, too. The Fed could best do this by explicitly adopting a nominal-spending target. The more credible that target, the less the Fed would have to do to reach it: Private-sector expectations of future spending powerfully influence current spending levels. Knowing that the Fed would do whatever it takes, including aggressive open market operations, to maintain steady nominal GDP growth would create confidence and more economic certainty for households and firms — regardless of whether the government was cutting spending. The effect should be to offset every dollar of reduced government spending by roughly a dollar of increased private spending.

The Fed cannot undo the effects of any bad policy Congress enacts: It can’t, for example, restore incentives to work, save, and invest if legislators stifle them. What the Fed does have the power to do is to keep the Keynesian nightmare from taking place. We might fall off the fiscal cliff and then go into a recession. But if we do, it will be because the Fed failed to do its duty. [Emphasis added]

As James Pethokoukis and Scott Sumner have recently noted, Mark Carney, the well-regarded Governor of the Bank of Canada who was recently named the next head of the Bank of England, has all but endorsed a nominal GDP level target. The following is drawn from a recent article in the Daily Telegraph cited by Pethokoukis and Sumner:

“To ‘tie its hands’, a central bank could publicly announce precise numerical thresholds for inflation and unemployment that must be met before reducing stimulus.”

He added: “If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP level target could in many respects be more powerful than employing thresholds under flexible inflation targeting.” [Emphasis added]

Ben Bernanke, chairman of the Federal Reserve, announced earlier today that the Fed will embrace a “tie its hands” policy, as Binyamin Appelbaum reports:

The Federal Reserve said Wednesday it planned to hold short-term interest rates near zero so long as the unemployment rate remains above 6.5 percent, reinforcing its commitment to improve labor market conditions.

The Fed also said that it would continue in the new year its monthly purchases of $85 billion in Treasury bonds and mortgage-backed securities, the second prong of its effort to accelerate economic growth by reducing borrowing costs. …

The Fed said it expects prices to rise at or below the 2 percent annual pace that it considers most healthy. But the Fed also said that it was inclined to tolerate medium-term inflation as high as 2.5 percent without breaking its focus on reducing the unemployment rate. [Emphasis added]

That is, as Charles Evans of the Chicago Fed has recommended, the Fed has announced “precise numerical thresholds for inflation and unemployment that must be met before reducing stimulus.”

Scott Sumner, however, emphasizes that this is still very far from a nominal GDP level target, which he, like Carney, believes to be a superior approach:

The Fed had already committed to keep money easy well into the recovery.  This makes that promise more explicit.  Which is good.  But it’s still a long way from level targeting.  A Japanese-style zero percent NGDP growth path over the next 2 decades is fully consistent with this commitment.

To return to our recent discussion of Sen. Marco Rubio’s views on monetary policy, Josh Barro wrote the following in light of the Fed announcement:

Hey, where’s Marco Rubio’s statement praising today’s Fed statement? This is the rule-based monetary policy he wanted, right?

I’m more inclined to take Sumner’s view:

Of course the critics do have a point; it’s dangerous to set a vague composite target constructed of inflation and unemployment, where the Fed reaction function is unclear.  Today they’ve made it a bit clearer, and they’ve made monetary policy a tad more stimulative.  But they still have a long way to go.

A vague composite target is not rule-based monetary policy. But it’s probably better than nothing.  



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