The House of Representatives and Senate have now approved separate plans to overhaul the federal tax system. It now appears likely that a reconciliation process will quickly produce legislation that can pass both chambers of Congress and be signed into law by President Trump. Though far from perfect – it still leaves us with a tax code that is far too complex and riddled with inefficiencies – the final bill, if passed, should nevertheless provide a noticeable boost to the US economy.
The tax bill will help the Federal Reserve, too. With improved economic performance, Fed officials can move with greater confidence to normalize monetary policy and rein in the scope of monetary policy by refocusing their efforts on stabilizing inflation.
Although Congress has given the Federal Reserve a dual mandate to achieve both price stability and maximum sustainable employment, the Fed makes its best contribution to maximizing employment by creating and maintaining an environment of stable prices.
That was Milton Friedman’s main message in the Presidential Address he gave to the American Economic Association 50 years ago, in December 1967.
This lesson was learned the hard way by the Fed during the 1970s, when its attempt to exploit a perceived Phillips curve trade-off to lower unemployment at the cost of higher inflation led, instead, to the worst of both worlds: high unemployment and high inflation. The subsequent Volcker-Greenspan consensus of successfully pursuing low inflation and inflationary expectations that evolved from the misguided policies of the 1970s supported healthy economic performance during a period commonly referred to as The Great Moderation.
Outgoing Fed Chair Janet Yellen re-emphasized Friedman’s message on the limited capabilities of monetary policy in an important speech last March, in which she attributed much of the disappointingly slow growth in employment and income since the Great Recession to “structural challenges that lie substantially beyond the reach of monetary policy.” Echoing Friedman, Chair Yellen noted, more specifically, that
Monetary policy cannot, for instance, generate technological breakthroughs or affect demographic factors that would boost real GDP growth over the longer run or address the root causes of income inequality. And monetary policy cannot improve the productivity of American workers. Fiscal and regulatory policies – which are of course the responsibility of the Administration and the Congress – are best suited to address such adverse structural trends.
The Trump administration has already taken first important steps to reduce some of the burdensome regulations that have raised operating costs and been the source of inefficiencies that have constrained growth. Regulatory reforms that affect labor markets, licensing agreements, the food and drug industries, power production, and a host of other areas have been a primary source of elevated business confidence. The higher confidence has contributed to stronger business investment and, if continued, will also promote labor productivity gains.
The corporate tax reforms at the heart of Congressional bills, particularly lower marginal tax rates, expensing of new investment, and the move toward a territorial system of international income taxation, will raise expected after-tax returns on investment. Additionally, the one-time low tax on repatriated cash and assets that corporations now hold overseas will put that valuable capital to work, whether businesses use the funds to invest in expansion plans or distribute them to shareholders. At the same time, workers will benefit from higher wages.
Both higher expected rates of return on investment and enhanced economic performance will put upward pressure on real interest rates and, by extension, the “natural” interest rate. In response, it will be appropriate for the Fed to quicken its monetary policy normalization with additional increases in its federal funds rate target. This rise in policy rate will be a reflection of the stronger economy, and will be necessary to prevent inflation from overshooting the Fed’s long-run two percent target. These monetary policy actions will work, therefore, to prolong rather than threaten the ongoing economic expansion.
Likewise, improved economic performance should give Fed increased confidence to move more quickly in reducing the size of its balance sheet, unwinding the effects of its three massive waves of quantitative easing. With mortgage markets functioning normally, the Fed should scale back its role in the mortgage and other credit markets, reducing asset price distortions and allowing funds to be allocated more efficiently across competing uses. Once again, more rapid policy normalization will contribute to an environment more conducive to healthy long-run growth.
Congressional tax plans will provide more than just a short-term boost to the economy. They will provide the Fed latitude to remove itself as an outsized force in the credit markets and refocus on its traditional central banking role of stabilizing prices. Fiscal and monetary policy will then be working together to create preconditions for a more robust and durable economic expansion.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. Mickey Levy is the chief economist of Berenberg Capital markets, LLC for the Americas and Asia and a member of the Shadow Open Market Committee. The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.
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