Fed’s attempt to accommodate expansionary fiscal policies will fail

The COVID-19 pandemic required unprecedented coordination of monetary and fiscal policy. Unconventional monetary policies were pursued to provide the fiscal space required to respond to the pandemic. 

The challenge now is normalizing monetary and fiscal policy and restoring macroeconomic stability. This requires a commitment to stable prices and debt levels, but the credibility of these two commitments is now called into question.   

Debt fatigue has put the country on an unsustainable debt trajectory. Major economic shocks have left the country with an unsustainable debt burden and an expanded role for the federal government in the economy. The current administration has further expanded the demands on fiscal policy, including investing in infrastructure, decarbonizing the economy, and redistributing income and wealth. To fulfill the commitment to stabilize debt, Congress must close the fiscal gap and bring expenditures into balance with revenues in the long term. Still, there is no indication that Congress will meet this commitment.      

In the absence of sustainable debt, it will be impossible for the Fed to fulfill its commitment to stable prices. The unconventional monetary policies pursued by the Fed have created the impression of a free lunch. The traditional boundaries between monetary and fiscal policy have blurred, and political actors now have a greater incentive to exploit the Fed for political purposes.   

The failure to commit to debt stabilization creates a fundamental conflict between monetary and fiscal policy. The Fed is now on the horns of a dilemma. If the Fed continues to accommodate expansionary fiscal policies, this could boost employment in the short run, but this puts upward pressure on prices in the long run. On the other hand, if the Fed fulfills the commitment to stabilize prices, this could result in higher levels of unemployment. 

Over the past two decades, the economy has experienced retardation in economic growth, with higher unemployment rates. This means that the attempt by the Fed to accommodate the expansionary fiscal policies pursued by Congress is bound to fail.      

Until 2021 the Fed was not forced to confront the horns of this dilemma. 

The unconventional operating monetary framework put into place in response to economic crises allowed the Fed to pursue accommodating monetary policy without triggering higher prices. 

But in 2021, the day of reckoning has arrived. The new operating framework has fallen apart, and expansionary monetary and fiscal policies have triggered inflation rates not seen since 1980. The inflation genie is out of the bottle.   

Some have argued that the Fed could normalize monetary policy by simply restoring a commitment to stable prices, as Fed Chairman Paul Volcker did in 1980. Mr. Volcker found that putting the genie back in the bottle was no easy task, but he did not face the horns of a dilemma confronting the Fed today. 

During the “Great Moderation” of the 1980s and 1990s, Congress fulfilled the commitment to stabilize the debt. After two decades, in the 1990s, expenditure was finally brought into balance with revenues, and the debt burdens were reduced. 

On the other hand, current Fed Chairman Jerome Powell has committed the Fed to do whatever it takes to achieve the target levels of unemployment set by Congress. A failure to execute price stability and debt sustainability means that the economy will most likely experience stagflation as it did during the 1960s and 70s.   

Today, a strong case can be made for replacing the Federal Reserve Act with a charter establishing rules-based monetary policy (Hetzel 2020; Selgin 2020; Michel 2022). The charter should restore Fed independence and separate monetary and fiscal policy. It should replace the discretionary monetary policy with a rules-based monetary policy. There is controversy regarding the optimum design of a rules-based monetary policy. 

In the tradition of Milton Friedman, some economists argue for monetary rules designed to keep nominal GDP on a stable full employment path (Beckwith 2017; Sumner 2014). A target rate of growth of the money supply would be set consistent with that growth rate in nominal GDP. Other economists argue for the rule-based monetary policies first proposed in the pioneering work of John Taylor (1993). These rules would rely on the traditional monetary policy tools, adjusting the interest rates to achieve target levels of inflation and unemployment.     

An alternative approach to monetary policy would eliminate the Fed and central bank control of the money supply entirely (White 2015). Before the 1913 Federal Reserve Act, the U.S. had such a “free banking” system. 

In a “free banking” system, private banks issue their own paper currency. These “banknotes” are then redeemable in underlying money, usually gold or silver. Some economists argue for a “free banking” system where banknotes are redeemable in a standard bundle of diverse commodities. 

Mr. Friedman (2014) argued for a “free banking” system in which banknotes are redeemable in a fiat currency fixed in supply. Supporters of “free banking” say that the commitment to stable prices is more credible in this monetary system than relying on fiat money and central bank control of the money supply.

At the end of the day, the question is whether any monetary system can fulfill the commitment to stable prices when the government fails to commit to sustainable debt. 

The experience in high debtor countries is that in the long run, a failure to commit to sustainable debt levels exposes the country to devaluation of the currency and debt default. 

The U.S. is not immune to these risks even though it prints a reserve currency.

• Barry Poulson is Professor Emeritus University of Colorado Boulder. He is co-author with Steve Hanke and John Merrifield, ‘Public Deb Sustainability: International Perspectives,’ Lexington Press, January 2022.

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