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--Choice of Next Fed Chair Signals Likelihood of Policy Coordination, Economist
--Expansive Fiscal Countered By Rate Hikes Hurts Debt Sustainability; Possible
--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
"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
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: firstname.lastname@example.org