Fiscal Policy Success Is All About Monetary Policy

Suppose that the US were to adopt a large fiscal stimulus program, with the aim of boosting aggregate GDP in 2020 by a considerable amount (15%?) relative to current forecasts.   Under what circumstances would such a program be successful in achieving its goal?   In this post, I’ll argue that the answer depends critically on the monetary policy response to the plan.  I’ll describe two possible changes in the Fed’s operating framework that would lead its policy choices to be more supportive of the desired aggregate growth outcomes. 

There are two possible monetary policy responses.  

Response 1: The Fed’s chosen path of interest rates is higher than currently anticipated.  

Assuming that inflationary expectations are little changed, the Fed’s tightening will drive down aggregate demand in unstimulated sectors of the economy.   Suppose, for example, the government increased infrastructure spending greatly.   If the Fed were to raise interest rates, it would constrain the growth of household consumption and business investment.  By tightening sufficiently, the Fed could essentially eliminate the effects of any stimulus program on aggregate output.  All that would happen is that the composition of aggregate activity would swing away from private expenditures toward public expenditures. 

Response 2: There is little change in the evolution of interest rates.

Without tighter monetary policy, an increase in public expenditures will not crowd out private consumption and private investment.  In fact, if inflation expectations were to rise in response to the increase in economic activity, then there would be a decline in the real interest rate.  That decline would generate more private sector investment and private sector consumption. 

To sum up: an aggressive demand stimulus plan can achieve its aggregate objectives if (but only if) the Fed does not tighten significantly in response to the program.  

There are two changes in the Fed’s approach to monetary policy that would make the second (no-tightening) scenario more likely.  

The first change is that the Fed should use its tools to constrain inflation, but not to constrain growth.  The Fed is required by statute to use monetary policy to prevent unduly high inflation. However, the Fed is also required by statute to promote (employment) growth if it can do so without generating unduly high inflation.  

Given current macroeconomic circumstances, I see several reasons why a (well-designed) pro-growth stimulus program need not generate unduly high inflation:

  • as I argue here, a large increase in aggregate demand could incent adoption of pent-up technological innovations.  The resultant increase in productivity would lower business’ costs and pressures on inflation.   
  • corporate profits are expected to remain very high by historical norms for many years.   Businesses may choose to react to cost pressures through profit reduction as opposed to price increases. 
  • the Phillips curve seems to have flattened greatly in recent years
  • as I argue here and here, the government can adopt supply-side policies that would constrain inflationary pressures if they do develop.

The second change in the Fed’s framework is that it could increase its inflation target.  Despite the above considerations, it is possible that fiscal stimulus could increase inflationary pressures.   But such an increase could be seen as an opportunity for the Fed, as opposed to a reason to tighten policy.  

Several economists have argued that the Fed should adopt a noticeably higher inflation target so as to lower the risk of future prolonged stays at the zero lower bound.   The problem is that inflation has been running below the current target for years.  It seems unlikely to me that simply announcing a new target would, in fact, make it credible. The Fed would have to build the credibility of its new target by allowing inflation to rise toward (and possibly overshoot) it.  If an aggressive stimulus plan were to generate significant inflationary pressures, the Fed would have the perfect opportunity to build up the credibility of a new higher target.

Thus, there are good reasons to believe that Fed need not tighten in response to fiscal stimulus.  In that case, fiscal policy can generate materially super-normal aggregate growth over the next few years. 

I’ll close with a thought about risk.  There is a risk that fiscal stimulus would engender significantly tighter monetary policy, and so would fail to achieve the desired aggregate growth rates.  In my view, it is appropriate to pursue materially super-normal economic growth despite this risk.  But it is important for fiscal policymakers to be clear with the public about the existence of this risk.  As well, and as discussed above, sufficiently tighter monetary policy would depress unstimulated economic activities.  This risk underscores the need for fiscal policymakers to be deliberate in their choices about the composition of fiscal stimulus between private sector demand and public sector demand. 

N. Kocherlakota

Rochester, NY, February 28, 2016

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