The Risks of Fiscal Turmoil for Monetary Policy: Some Lessons from History
The recent financial crisis and recession in the U.S. and the massive fiscal stimulus package that followed it has led to a fiscal deficit close to 9% and a ratio of debt to GDP close to 90%. In addition, demographics point to ever rising Social Security and Medicare entitlement expenditures and the possibility of even larger deficits and debt ratios in the not too distant future. These facts raise the specter of a disconnect between a relatively stable monetary policy and a relatively unstable fiscal policy and raises the question whether the Fed can insulate itself from the fiscal turmoil.
Monetary Policy and Economic Performance
The Federal Reserve is in an uncomfortable predicament. It has reduced interest rates to zero, pumped trillions of dollars into the financial system, and is now engaging in “operation twist”. Bond yields are low, yet the economy is not responding. Congress, financial markets and the media always turn to the central bank in times of trouble, and the Fed feels pressure to comply and ease monetary policy further. The Fed has not come to grips with the limitations of monetary policy. Complying with the pressure to ease further—to do something—may involve high risks, even if inflation remains low in the near term.
Nominal GDP Targeting
Recent months have witnessed an upsurge of interest in the idea that, to quote The Economist, “… rather than directing monetary policy to hit inflation targets (as they have done for the past 20 years) central banks should take aim at nominal GDP (or NGDP).” That is, the idea is that central banks should conduct monetary policy so as to keep the growth rate of aggregate nominal spending at a specified numerical value. This value would equal the sum of the central bank’s target inflation rate (say, 1.5% per annum) and the economy’s long-run average rate of output (real GDP) growth (say, 3.0%). The belief of supporters of the suggestion is that successful achievement of this objective would yield the same long-run average inflation rate as would achievement of an inflation target of 1.5%, and also the same long-run growth of output, but would do so with a reduced volatility of output fluctuations.
Fiscal Dimensions of Inflationist Monetary Policy
The broad-based support for price stability is at risk today in the United States and in Europe. Prominent voices in academia, the media, the International Monetary Fund, and inside the Federal Reserve have proposed that the commitment to price stability should be relaxed in one way or another to concentrate on achieving more pressing objectives. The inflationist policy proposals are varied with respect to their objectives and operating guides. For instance, the objectives range from reducing unemployment, to depreciating the real public debt, to facilitating international adjustment within the Euro area. In the paper, I compare and contrast various inflationist proposals and consider their overall advisability in light of lessons from the Great Inflation.
What the Political System Can Do to Help the Fed
The Federal Reserve faces mounting political pressures. Their intensity levels have reached -- and may even exceed -- those last felt during the days of the Volcker disinflation, three decades ago. Critics of the Fed have raised their voices, using colorful language that has taken many listeners aback. Recent examples have been so striking that they need not be mentioned specifically -- their sound still rings in our ears.
The Dueling Mandate
I propose that the Federal Reserve consider declaring victory and simply announce what it believes – that price stability is its first priority, as price stability is the necessary precursor for sustaining long term maximum employment. This interpretation of the dual mandate can be accomplished, I believe, without legislation.
The Prospects for Inflation Ahead
Most observers today argue that since core inflation is considerably below the implicit inflation target of 2%, and unemployment and the output gap are still too high, that inflation is not an important worry for policy makers. Yet commodity prices are rising and headline inflation is also rising. It will likely take a long time for headline inflation to feed into core inflation through the conventional mark up channels but once it does it will be hard to dislodge as the experience of the Great Inflation taught us.
Evaluating QEII: A Rationale to Exit
Fortunately, QEII has not jarred market expectations; mark that up to the lingering low inflation – a typical cyclical pattern following recession. Now, with economic performance clearly improving and inflation rising, the risks of this unprecedented monetary expansion are increasing. Consequently, the Fed must set out an exit strategy, including a framework for managing reserves and normalizing interest rates.
Monetary Policy and the Behavior of Banks: Lessons from the 1930s for the 2010s
The Fed continues to reassure its critics that it will be able to identify changes in the economy quickly enough to prevent an inflationary surge. But critics are skeptical for good reason. There is cause for concern that the Fed may be slow to detect a sudden shift in the money multiplier. That concern – which is informed by an understanding of the micro-foundations of the money multiplier, as illustrated by the history of the 1930s – is the subject of this article.
Monetary Standards and the U.S. Constitution
With the arrival of Representative Ron Paul as Chairman of the House Committee on Banking, the interest in considering a meaningful monetary standard for the United States has presumably increased by a substantial amount. It is important, then, to consider whether the Gold Standard, which Rep. Paul has championed over many years, is itself the best available monetary standard to adopt as a guard against inflation (and deflation).
Congressional Oversight of the Federal Reserve
Congress cannot reasonably and reliably hold the Fed accountable for exceeding its authority or for a dereliction of duty after the fact without clarifying Fed responsibilities before the fact. Markets are left guessing what the Fed will do in particular circumstances, increasing uncertainty and impeding long-term business planning to invest and create jobs.
Targets for Monetary Policy: Inflation, Exchange Rates, and Others
It is well known that most leading central banks have been, over much of the past 15-20 years, conducting monetary policy according to some variant of inflation targeting, implying that maintenance of a low and stable overall inflation rate is (in principle) the predominate objective. Prior to the financial crisis of 2008, this approach was much favored by academic monetary economists, as well as central bank officials and economists. The intensity of the crisis and our continuing slow pace of recovery have served, however, to diminish support for inflation targeting (IT). Quite recently, as a possibly related matter, there has been an explosion of news items concerning the management of exchange rates, those of China and Japan being especially prominent, and with concern raised by the possibility of widespread trade wars of the “beggar thy neighbor” type, somewhat like those that contributed greatly to the disastrous severity of the Great Depression of the 1930s.
Appropriate Roles of Monetary and Fiscal Policies
The financial crisis and recession are over. Global economies are rebounding at a healthy albeit uneven pace. The US is recovering slowly. Inflation is low in the US and Europe, and the probability of deflation is low, while Japan continues to struggle with mild but persistent deflation. Inflation pressures are mounting in fast-growing emerging nations.
Managing Monetary Policy at the Zero Interest Bound
The Federal Reserve’s near zero interest rate policy and $2 trillion dollar balance sheet have done much to stabilize economic and financial conditions in the United States. Yet the recovery from the Great Recession is slow. Net private job creation remains too low to absorb the secular growth in the labor force, let alone what is needed to return to work those who lost their jobs in the Great Recession.
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