The Fed has credibility as an inflation fighter and a reputation
for independence, but Weinberg and Haltom say that can’t be counted on.
“In practice … a central bank’s credibility cannot constrain
fiscal policy in any meaningful sense,” they write. “It cannot stop
fiscal policymakers from running budget deficits that continually expand
the debt. As a result, whether high debt levels would lead to inflation
depends critically on whether the public believes fiscal authorities
will balance the intertemporal budget constraint, or instead leave
fiscal imbalances to be addressed by inflation.”
In a fiscal crisis, the Fed would be forced into “difficult
short-term tradeoffs” — “the economic pain associated with fiscal
crisis versus the longer-term costs of central bank intervention to
reduce debt levels — including the risk of inflation, damaged central
bank credibility, and a precedent for rescuing the government from its
debt.”
In other words, if high debt burdens increased long-term interest
rates that threatened economic growth, the Fed might feel it had no
choice but to run a more expansive monetary policy in an effort to boost
the economy and alleviate the debt burden even at the cost of higher
inflation.
But there is no easy way out as the Richmond Fed staffers see it:
“Being near the fiscal limit is enough to enable an equilibrium in which
markets expect the central bank to accommodate the debt with inflation
in the future. The public’s expectation of higher inflation can push
actual inflation higher before the central bank decides to create a
single dollar.”
Weinberg and Haltom write that the Fed can do its best to preserve
its credibility by committing to price stability, meeting its inflation
target and proclaiming its independence, but they say “these steps may
not be sufficient” in the face of relentlessly rising government debt.
“(F)fiscal policy that does not contain the debt may lead to
inflation even if monetary policymakers have the best intentions,” they
write. “This is due to the incontrovertible nature of the government’s
intertemporal budget constraint.”
“When the expected path for fiscal policy does not by itself
achieve balance in the constraint over time, the price level is the only
other factor that can adjust to provide it,” they add.
Even if the central bank does inflate, Weinberg and Haltom doubt
whether it can inflate enough to fully offset debt burdens.
Ultimately, they say, it’s up the fiscal authorities, not the
monetary authorities to deal with the debt problem. They suggest that
fiscal policy rules be adopted.
“(I)t may be possible to create better rules for the more objective
aspects of fiscal policy,” they write. “Just as Congress has agreed to
set long-run objectives for the Fed while leaving day-to-day policy
choices to independent monetary policymakers, fiscal policymakers could
adopt objective long-run goals for fiscal policy — such as appropriate
long-run targets for the ratio of debt to economic growth, guidelines
for when unusual circumstances justify a large increase in debt, and how
quickly fiscal imbalances should be resolved in that situation…”
But they acknowledge that U.S. politicians can always disregard the
fiscal rules just as some European government disregarded the fiscal
guidelines of the Stability and Growth Pact inked when the euro-zone was
created.
“Ultimately, the solution to current fiscal imbalances will require
our elected authorities to make difficult decisions,” Weinberg and
Haltom conclude. “The Fed’s best contribution to this process is to
maintain its commitment to monetary policy objectives, including low and
stable inflation.”
“For the time being, markets appear to believe that fiscal
policymakers will put future debt, spending, and tax levels on a more
sustainable path,” the say. “If they are correct, our nation will not
have to experience the significant economic challenges of a world in
which those expectations have changed.”
** MNI **
[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$]
