MNI INTERVIEW: Trump-Fed Friction Would Lead to Vicious Circle

--Choice of Next Fed Chair Signals Likelihood of Policy Coordination, Economist

Tells MNI 

--Expansive Fiscal Countered By Rate Hikes Hurts Debt Sustainability; Possible

Recession

--Compromise Could Take Form of Temporary Price Level Target

--Research Paper To Be Presented at Boston Fed Conference

By Jean Yung

     BOSTON (MNI) - What happens when elected officials and the Federal Reserve

can't agree on economic policy? The two authorities working at cross purposes

will challenge the Fed's ability to stabilize inflation and create a serious

drag on economy activity, Duke University economist Francesco Bianchi, the

co-author of new research to be presented at the Boston Fed's annual economic

conference Saturday, told MNI in an exclusive interview. 

     President Donald Trump's choice for the next Fed chair will send a signal

to markets about how well fiscal and monetary policymakers will be able to

coordinate, something that has far-reaching implications that go well beyond the

potential path of U.S. interest rates and financial regulation, he said.

     If they can coordinate their actions, they can keep both inflation and the

nation's debt load in check. If not, a "vicious circle" where fiscal stimulus

drives rising deficits and higher inflation while monetary tightening dampens

growth could potentially trigger a recession, Bianchi said. 

     His paper, "The Dire Effects of the Lack of Monetary and Fiscal

Coordination," co-authored with Chicago Fed economist Leonardi Melosi, holds

special relevance at the present moment, when Fed concerns about overheating

labor markets are coming head-to-head with an administration committed to

stimulative tax cuts.

     Trump is mulling contenders to lead the Fed when Chair Janet Yellen's term

expires in February. In addition to the option of reappointing Yellen, he is

said to be considering current Fed Board member Jay Powell, former Board member

Kevin Warsh, and hawkish Stanford University economist John Taylor.

     "Appointing a more conservative or traditional chairman might increase the

perception that the central bank is going to stick to the policies of the past,"

Bianchi said. "If you do not pair this with a clear fiscal plan to stabilize

debt, that can create issues."

     When the government is not viewed by investors as being committed to fiscal

consolidation, the central bank has two choices: It can allow inflation to rise

to help stabilize the country's debt load or raise interest rates to keep

inflation at bay, Bianchi said. 

     Choosing the latter creates an institutional conflict in which a hawkish

stance on inflation could actually be counterproductive, Bianchi said. Rate

hikes will further damage fiscal sustainability as government interest payments

rise. If monetary tightening led to a recession, output and tax revenues would

fall and automatic stabilizers in government spending would drive outlays

higher.

     "Even if today there's not this conflict, the simple possibility that in

the future there might be this disagreement between the monetary authority and

the fiscal authority about what we should do with regard to debt and inflation

represents a drag on the economy today," Bianchi said. 

     "The simple fact that we don't have a clear plan about resolving the fiscal

issue can open the door to the possibility of a conflict."

     Bianchi cites the 1970s as an example of a time when the fiscal and

monetary authorities were in conflict. Fed policy accommodated fiscal policy

through the '60s and '70s, leading to high inflation. 

     "One tends to think of high inflation of the '70s as a purely monetary

phenomenon, but you could also interpret it as a monetary and fiscal phenomenon

-- a large increase in spending that started in the mid-'60s that was initially

accommodated by the Federal Reserve," Bianchi said. "There were several

disinflationary attempts by (then-Fed Chair Arthur) Burns, but all those

attempts failed." 

     Transcripts from the period show that Burns often succumbed to the requests

of the White House to abandon a more contractionary monetary policy.

     That the Fed stands as an entity independent of political pressures "is a

little bit of an exaggeration," Bianchi said. 

     Burns' successor, Paul Volcker, is generally credited with taming

inflation, but his efforts didn't bear fruit until late 1981, more than two

years after President Jimmy Carter appointed him, Bianchi noted. Volcker's

accomplishment owes at least as much to the fiscal commitments of the Reagan

administration as the Fed's rate policies, Bianchi said.

     "Volcker was a hawkish chairman, but the Carter administration pressured

him to introduce credit controls and cut rates. Things change when Reagan gets

elected, partly on a tough platform with regard to inflation, and he gave full

support to Volcker," Bianchi said. 

     The current Republican initiative on tax reform that would amount to a $1.5

trillion cut over a decade could result in a fiscal shortfall estimated at

several trillion dollars, according to budget analysts. Republicans say they

expect a surge in economic growth and the elimination of deductions to help pay

for the plan. 

     But the Yellen Fed would likely view the stimulus as counterproductive. The

Fed chair said in December that there was no need for additional fiscal stimulus

because the economy was already close to full employment. The Fed might feel

compelled to offset the stimulative effect of the tax cut with higher interest

rates, bringing the two authorities into a state of conflict.

     The authors suggest a strategy that could split the difference between

policymakers and moderate the adverse effects of conflict: Allow the inflation

target to rise for a while before returning to the 2% target.

     They could "coordinate on a policy in which a little inflation is generated

to wash out part of debt that was accumulated during an exceptionally large

recession," Bianchi said. "If you let inflation rise in part, that will mitigate

the fiscal issue and make long-run fiscal discipline more likely." 

     Adopting a temporary price-level target, an alternative monetary policy

framework endorsed by San Francisco Fed President John Williams in May and this

week by former Fed Chair Ben Bernanke in a speech at the Peterson Institute, "is

very much in line with our proposal," Bianchi said. 

     "The equilibrium that comes out of our policy can be very similar to that

of temporary price level targeting," in which the central bank commits to

keeping the price level on a steady upward path, Bianchi said. When inflation

falls below 2%, the Fed would make up for the surge by keeping inflation above

target long enough to return to the prior price level trend. 

     But for such a proposal to succeed, the government also has to stake out a

path consistent with the Fed's approach, such as explicitly committing to

stabilizing one part of the budget, Bianchi noted. That would also help markets,

which currently price moderate growth and inflation going forward, digest a

major policy shift.

     "If agents in the economy perceive this increase in inflation as necessary

to alleviate the fiscal issue, they might find it more credible," he said. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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