By Steven K. Beckner
Among the forces that could impact growth and inflation and in turn
monetary policy in coming years, Leeper lists an extension of the Bush
tax cuts; potential deficit cuts, bail-outs of state governments;
expenditures on bankrupt government-held Fannie Mae and Freddie Mac, and
a reversal of the Greece-related “flight to quality” that has swelled
demand for U.S. government debt.
Leeper says these are “the types of news that could cause
significant revaluations of government debt, with resulting impacts on
inflation rates and real activity.”
“Most of these examples would not even generate a flutter in
inflation during normal times when other fiscal adjustments can be made
to offset their impacts on the value of debt,” he says. “But in times of
fiscal stress, when people’s expectations of fiscal policies are
unanchored and susceptible to wide swings, they could cause important
shifts in aggregate demand to which central banks may be tempted to
respond.”
“To determine whether a monetary policy response is appropriate,
central banks need to have a firm understanding of all the potential
sources of the demand fluctuations,” he cautions.
Although some have expressed fear of hyperinflation, Leeper says,
“the reason that high inflation is a low-probability event is because
people believe that some entitlements reform is quite likely in the
future.”
However, he warns, “Policymakers who use the low probability of
high inflation as a justification for inaction will change people’s
beliefs about future policies and convert high inflation into a far more
likely outcome.”
Leeper also warns central banks against overreacting to an updrift
of inflation if it is caused by perceptions that the government will be
unable or unwilling to stabilize its debt.
“Central banks might reasonably react to the scare by preemptively
tightening policy, which may slow the economy but will do little to
combat the incipient inflation, which is driven by fiscal factors
outside the central bank’s control,” he writes. “It will be important
for central bankers who wish to keep inflation low and stable to
understand the subtle ways that fiscal stress can affect the macro
economy.”
Arguing for the development of a fiscal “science,” Leeper poses a
number of questions that economists need to ask:
1. Are there circumstances under which deficits (surpluses) should
be permitted to permanently raise (lower) the debt-GDP ratio or should
debt always be retired back to some long-run target?
2. Should there be a long-run target for debt? What should it be?
3. Should government spending, taxes, and monetary policy be
adjusted to stabilize debt?
4. How rapidly should debt be retired back to target?
5. What are the macroeconomic effects of certain government
spending and tax changes in well-specified thought experiments?
6. What are a country’s fiscal limits and how much government debt
can it support before markets deem the debt to be risky?
7. Are there times when monetary policy should support bond prices
and maintain the value of debt? What are those times?
8. Should monetary and fiscal policy behave in fundamentally
different ways in an era of fiscal stress than they do in normal times?
Though much of his 56-page paper deals with inflation, Leeper
closes by dealing with recently concerns about possible deflation.
“Chairman Bernanke has suggested that if those worries intensify,
the Fed is prepared to take further policy actions,” he notes before
asking, “Where is fiscal policy in this conversation?”
There are “ways in which fiscal policy can contribute to combatting
deflation, particularly when the central bank’s interest rate instrument
has fallen as far as it can,” he writes. “Those ways entail current
fiscal expansion that brings no immediate prospect of higher future
surpluses or news that surpluses will be lower in the future.”
But Leeper observes that “fiscal news in the United States lately
is all about plans to raise future surpluses. U.S. fiscal policy, like
its European counterparts, is too busy flip-flopping to be a player.”
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** Market News International **
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