Academic journal article The Cato Journal

Monetary Policy and the Growing Fiscal Imbalance

Academic journal article The Cato Journal

Monetary Policy and the Growing Fiscal Imbalance

Article excerpt

The federal government has made commitments to increase entitlement spending rapidly in coining decades. In particular, Medicare expenditures are scheduled to balloon. My expectation is that these commitments will be met for many years by the current unfunded, pay-as-you-go system rather than being pre-funded, a preferable approach, with marketable investments. The 2005 discussion of personal accounts for Social Security didn't make much progress, nor is any marketable funding expected for the Medicare liability. Based on this assumption of a continuation of business-as-usual in Washington, this article focuses on the coming acceleration in outlay growth, in the context of rapidly growing unfunded entitlement liabilities, will affect monetary policy.

The Impact of Fiscal Profligacy on Monetary Policy

In the near term, the impact is limited. The Federal Reserve is powerful and independent. With the debt-to-GDP ratio at 37 percent or so I expect the Fed to set interest rates based on its assessments of inflation, employment, and growth. Looking several years ahead, however, we should assume a combination of increases, relative to GDP, in outlays, receipts, the deficit, and debt. That combination will presumably reduce the economy's real growth potential somewhat.

Fiscal profligacy creates multiple issues for monetary policy:

* The Fed will face increased political pressure to keep interest rates low in order to encourage short-term growth and to hold down the cost of funding the national debt.

* The impact of Fed or private sector errors in the cycle may be magnified. A 1 percent miss on the inflation rate probably poses more risk to an economy with a 75 percent national-debt-to-GDP ratio than it does to our present economy with half of that national debt burden.

* As the fiscal problem grows, the Fed will in some way be responsible for thinking about and commenting on fiscal trends, drawing it into a contentious political process and creating new uncertainties about monetary policy.

Fortunately, economics is relatively clear that fiscal problems should be dealt with through fiscal tools (for example, spending restraint and a growth-oriented tax system), while monetary tools should focus on monetary issues (inflation, deflation, dollar weakness). I think U.S. monetary policy needs to recognize currency stability as an important ingredient of a low-inflation environment.

Inflation problems followed the weak-dollar policies of the 1970s and the mid-1980s, a deflation problem followed the strong-dollar policy of the late 1990s, and a growing inflation problem has appeared since the dollar weakness of 9.002-04. The Fed should recognize the link between the value of the dollar and the resulting inflation and deflation tendencies in the economy. In my view, this change would reduce the relatively wide fluctuations in U.S. interest rates and inflation rates and thus add to average growth. As the country's potential growth rate changes, with different demographics, these fiscal challenges will provide an important opportunity for additions to the Fed's current monetary policy framework.

As a practical matter, Europe and Japan face larger and more immediate fiscal imbalances (Table 1), so the Fed will gain from their experiences dealing with them. The European Central Bank has made it repeatedly clear that it will not compromise its inflation-fighting mission in response to Europe's structural problems, growth rate, or deficit-funding issues. Of particular interest to the United States, though not an outcome we should wish on Europe, would be a European recession at a higher level of interest rates, a scenario that would create a spike in Europe's already-large fiscal deficit and debt. This would test whether the ECB's independence could be maintained under stress. If so, the euro would retain market confidence, leaving the crisis in the fiscal and political realm rather than transferring it to monetary policy. …

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