By Ian McKendry

WASHINGTON (MNI) – The Federal Reserve is better suited for
stabilizing the economy against “aggregate shocks” than the fiscal
authority, in part, because the political makeup of the fiscal authority
is not well suited for the timely, subtle reactions necessary, St.
Louis Federal Reserve President James Bullard argued in an economic
paper released Friday.

Bullard also argues that the Fed’s quantitative easing programs
have been effective since interest rates hit the zero lower bound.

Bullard’s paper, titled “Death of a Theory,” says that it was
widely accepted pre-2007 that stabilizing the economy in the short term
should be left to the monetary authority.

However, after the Fed lowered interest rates between 0 and 25
basis points in 2008, the thought process changed, assuming that fiscal
policy would be more effective for stabilizing the economy because the
monetary authority could no longer target nominal interest rates.

Bullard argues that monetary policy can be effective at the zero
lower bound because the Fed can still influence inflation expectations
and that in practice, fiscal policy makers turned to the international
debt markets, taking on burdensome debt to finance stimulative measures.
He said these have been interpreted by the private sector as pushing
taxes down the road, thereby offsetting the benefits.

Bullard said by realizing economic shocks should be handled by the
monetary authority, while fiscal policy focuses on setting medium- and
long-term tax and spending programs, the theory that fiscal policy is
better suited to handle economic shocks is no longer true (the “death”).
He added that the “conventional wisdom” in the preceding decades that
stabilization policy should be left to the monetary authority is being
reestablished.

“A key issue that immediately arose was whether monetary
stabilization policy could still be conducted effectively at the zero
lower bound on nominal interest rates,” Bullard said.

“If it could, then there would be less need to move toward fiscal
programs for stabilization, because the existing conventional wisdom —
‘leave it to monetary policy’ — would still be valid,” Bullard said.

Bullard cited a 2002 speech by Fed Chairman Ben Bernanke in which
he states “A principal message … is that a central bank whose
accustomed policy rate has been forced down to zero has most definitely
not run out of ammunition.”

Bullard also said “it seems obvious that existing political
processes will not be of the type that can easily react in a timely and
subtle way to macroeconomic shocks.”

Rather, Bullard said fiscal policy should focus on tax and spending
decisions that “should be set in a way that fosters maximum economic
growth over the medium and longer run and that garners enough political
consensus to remain stable over long periods of time.”

Bullard argued that another problem with the belief fiscal policy
is better suited for economic stabilization is the recent practice of
fiscal policymakers tapping international debt markets.

He said in the recent crisis the practice has resulted in “too much
debt” or the point when the temporary benefits of defaulting exactly
offset the benefits of continuing to have access to the credit markets.

“To say that monetary stabilization policy cannot be effective once
the zero lower bound has been encountered is to say that the central
bank cannot create inflation once this condition is met,” Bullard said,
adding that instead he thinks the Fed has been able to influence
inflation and inflation expectations.

** Market News International Washington Bureau **

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