Free Trial

MNI INTERVIEW: Fed's Poor Fiscal Modeling Risks Inflation

MNI INTERVIEW:NY Fed Adviser Fears Price Expectations To Spike

The Federal Reserve's failure to fully incorporate fiscal developments into its monetary policy analysis risks a return to a 1970s-style capture of the central bank that could cement higher inflation or even generate a loss of confidence in U.S. debt, Eric Leeper, a former Atlanta Fed and Fed board economist, told MNI.

"I think they have a pretty narrow view of how fiscal policy affects the economy. So they think about it in terms of what are government purchases, what is disposable income, that kind of thing, and they completely set aside any role that debt has," said Leeper, who gave a presentation on the issue at this year's Jackson Hole conference.

"That's a huge mistake," he said. "When you're going into an environment, like ours, with debt at 100% or maybe 120% of GDP depending on how you measure it, it's a really big deal. And these fiscal consequences of changes in interest rates can be huge, and they run exactly counter to what the Fed is trying to achieve by raising rates."

The proactive fiscal policy reaction to the Covid recession stands in stark contrast to the aftermath of the Great Recession, when Congress was pushing austerity policies during a slump, forcing the Federal Reserve into an even more prominent role that earned it the nickname of 'the only game in town.' Fast forward to the present, with some USD6 trillion in fiscal support to businesses and households already distributed, and new infrastructure spending under active debate.

The shift caught the Fed by surprise but did little to alter the central bank's policy calculus, except insofar as the boost to economic growth is seen as speeding a tapering of QE.

"The problem with some of this fiscal inflation that we're talking about is, if people see that we're issuing a lot of new debt and they don't expect that taxes are going to rise in the future, that's going to be inflationary, and there's nothing the central bank can do about it," Leeper said.

"Sure, they can in the short-run reduce inflation, maybe by creating a big recession. But ultimately the fiscal inflation is going to kick in. So it's really a different world than the central bank and its models want to live in."


"If you're working with a model that just assumes all that away, where are we headed? It could be a rerun of the 70s where the Fed raises interest rates and they see that it doesn't slow down inflation so they raise them a little bit more, it doesn't slow down inflation," said Leeper.

"I don't know that that's the most likely outcome but it's a possibility and it's one that they wouldn't detect in their model because their model would say oh inflation is higher than we expected it, it must be because of some markup shock or some international shock, they wouldn't attribute it to the fact that they got fiscal policy wrong. Because they just assume that it's always what they want it to be."

Preventing a 1970s repeat would require not just monetary tightening, said Leeper, but also a confidence in financial markets that the U.S. government has some intention of reducing its debt load over time.

"One of the things that really needs to be emphasized is the special status that U.S. Treasuries have. They are the world's money. But that's a status that can be fragile. And you start throwing away all these norms and it will disappear," Leeper said.

Moreover, the larger debt load, in addition to the Fed's 2008 shift toward payment of interest on bank reserves as a way to control the effects of QE on benchmark borrowing costs, might make the Fed beholden to Congress in undue ways.


That would be an ironic result of an attempt to artificially separate fiscal and monetary actions too drastically, he said.

"Some years ago I testified before Congress and they were just railing against the Fed particularly because some of these interest payments go to foreign banks," he said. "But that was at a time when these interest payments weren't really pinching. When it really starts impinging on what they want to do, I think there will be all kinds of heat," he said of the interest on reserves tool.

Because the Fed is aware of this, Leeper added: "Then you ask, will that make them more hesitant to contract? When you're told don't worry about inflation the Fed has the tools to handle it. That isn't the question -- the question is will they use them?"

Leeper worries that the political debate in the U.S. has shifted too far in the direction of economists who advocate Modern Monetary Theory, which argues that fiscal deficit fears are often misguided and unfounded.

"I'm very worried about it," he said. "This does look like a free lunch, we can print money and we can employ everybody in the country that way and we don't have to worry about any negative consequences from that."

MNI Washington Bureau | +1 202 371 2121 |
MNI Washington Bureau | +1 202 371 2121 |

To read the full story



MNI is the leading provider

of intelligence and analysis on the Global Fixed Income, Foreign Exchange and Energy markets. We use an innovative combination of real-time analysis, deep fundamental research and journalism to provide unique and actionable insights for traders and investors. Our "All signal, no noise" approach drives an intelligence service that is succinct and timely, which is highly regarded by our time constrained client base.

Our Head Office is in London with offices in Chicago, Washington and Beijing, as well as an on the ground presence in other major financial centres across the world.