In the Shadow of Fiscal Policy

Douglas W. Elmendorf and Vincent Reinhart

As the government moves closer to finalizing a fiscal stimulus package, the Federal Reserve must decide what influence, if any, the legislation should have on policy. Two former Fed economists, Douglas Elmendorf of the Brookings Institution and Vincent Reinhart of the American Enterprise Institute, argue that fiscal stimulus shouldn’t stop the Fed from significantly cutting rates.

For all the hubbub surrounding the Fed’s emergency interest rate cut last Tuesday, it is important to remember that monetary policy’s effects on the economy play out gradually over time. Thus, the three-quarters percentage point move should be valued not in terms of points on the Dow Jones Industrial Average this month but rather in tenths on the unemployment rate and inflation late this year and next. And before we get there, the United States is almost certain to endure a significant bout of economic weakness.

The great gears of the Washington legislative machinery have been set in motion in a further effort to revive the flagging economic expansion. The apparent agreement between the president and leaders in the House of Representatives sets the broad outline of the likely package, but it only marks the start of the legislative process. No one can predict the outcome. Odds are that it will end up including tax rebates to households, incentives to businesses, and other provisions as well. Whether the economy needs the full extent of that impetus, or, if it does, will get its kick at the appropriate time, remain open issues.

The good news is that these political ambitions have been tempered by a consensus view on what makes fiscal stimulus effective. As Fed Chairman Ben Bernanke explained in testimony recently, any effective economic jolt must be implemented quickly, maximize the near-term stimulus per dollar of lower revenue or higher spending, and be temporary so as not to worsen the long-run budget outlook.

Chairman Bernanke should be congratulated for this good counsel. But he should also remember that he and his colleagues at the Federal Reserve will do more to shape the progress of the U.S. economy than any of those now contemplating changes in depreciation schedules. In particular, those setting monetary policy in the shadow of a potential fiscal initiative must remember three lessons if they are to steer the economy successfully around the shoals that are now evident.

First, fiscal stimulus might not happen. Although the president and congressional leaders have cooperated so far, whether they will ultimately succeed is far from certain. How much emphasis should be placed on encouraging household spending versus business spending? Should help for households be focused on tax rebates or include increases in spending on specific programs as well? With these and other issues not fully resolved, today’s cooperative spirit might turn into tomorrow’s frustration and disappointment.

Second, a fiscal stimulus package might be enacted but not be effective. Not everything being proposed as stimulus these days would have a noticeable effect on the economy. If the political process generates a fiscal program that does not get money out the door or hands it out in ways that do not spur demand for goods and services, then economic activity will not benefit and might even be hurt.

These two lessons tell us that monetary policymakers should not linger at the altar for an on-again-off-again fiscal suitor. The tool given the Federal Reserve — setting the overnight market interest rate — is uniquely flexible in the arsenal of policymaking. Chairman Bernanke and his colleagues should work on the assumption that the creaking machinery of Washington politics will deliver, at best, damaged goods on fiscal impetus. If the legislative outcome turns out better, the Fed can dial back on monetary stimulus later with little cost. If, instead, politics as usual prevail, aggressive monetary ease will be viewed as a well-timed counter-punch to Washington rope-a-dope.

Third, in the best of worlds, a well-designed fiscal stimulus will boost output only temporarily. This leaves the outlook for 2009 and beyond in the hands of Chairman Bernanke and his colleagues. The temporary support to spending of tax cuts or spending increases is no reason to stint on monetary stimulus that would bolster demand later.

Monetary policy inevitably requires a balancing of risks. To be sure, inflation excluding food and energy prices — so-called core inflation — has exceeded the upper end of the Fed’s implicit comfort zone during most of the past four years. Including food and energy prices, the overage has been much more pronounced. Therefore, the emphasis of some Fed officials on preventing further increases in inflation is understandable. However, core inflation exhibits substantial inertia, so upward movements in inflation usually occur gradually. In contrast, output and employment can slump more rapidly, and the fragile state of the financial system today accentuates the risk of a reinforcing downward spiral. With a possible plunge on one side of the road and a less abrupt embankment on the other, a wise driver stays on the side of the shallower drop.

The increasing probability of fiscal stimulus reduces the chance that the economy will fall off the steep side of the road. Given all the uncertainties that remain about fiscal policy, though, and the strong asymmetry in underlying economic risks, the Federal Reserve has no reason to stay its hand from easing policy significantly.