Tuesday, 29 June 2010

The revealed attitude of the Fed

Here's a little something on fiscal stimulus. It contains a suggestion I've seen from Tyler Cowen and Scott Sumner, among others:

...while the zero bound does not bind, the Fed might nonetheless be reluctant to engage in the appropriate amount of monetary expansion, and that a fiscal boost is therefore required. A potential response to this is that if the Fed has chosen the unemployment rate with which it is satisfied, it will simply offset any fiscal measures to push unemployment below that level.
That's only true if the Fed is assumed to be a simple (rational?) agent acting with just one lever: controlling the money supply in order to choose a balance between inflation and unemployment. However, it's very plausible that the Fed is not happy about the current unemployment rate, and recognises that it could and perhaps should increase inflation (or NGDP) to fight it. But it is also worried about its long-term credibility (as Ben Bernanke indicates in his answer to Brad Delong here, for example). If so, its reason for accepting unemployment is not to reduce current inflation, but to improve the future efficiency of the economy.

Plausibly, the Fed may believe that inflation caused by fiscal stimulus, and not offset by higher interest rates, will not damage its credibility in the way that large-scale QE might.

In fact, I believe this describes exactly the Fed's current attitude. Even if it's not Bernanke's personal opinion, we can infer a "collective attitude" from the joint behaviour of the Fed governors. In which case, fiscal stimulus is probably justified.

Then again, the "revealed attitude" of Congress is not helpful in this respect. The Fed may have to move if Congress won't, and find another way to keep its credibility. For example, by acting as a responsible agency which helps the economy recover. I hope the Bank of England is a bit more accommodating after the UK government's imminent cuts.

1 comment:

PunditusMaximus said...

It's also relevant that there is a Democratic President, so the Fed's informal target unemployment rate is much higher.