The post title is in response to a Matt Yglesias post entitled:
Does Ben Bernanke have a secret plan to stymie stimulus?
Matt begins his post as follows:
Scott Sumner wants an answer from Keynesians about how fiscal stimulus is supposed to help a depressed economy if the central bank is determined to offset any impact on total nominal spending.
The answer is that it can’t. The central bank can act faster and prevent fiscal reflation. But my question for Sumner is what makes him think that the central bank we have is doing this.
I believe Bernanke sincerely favors short term fiscal stimulus, and hopes it succeeds.
Now let’s stop talking about what Ben Bernanke believes, and start talking about how the Fed actually behaves. Here’s Matt again:
It appears to be the case that the real world Federal Reserve operates primarily by targeting interest rates, and in a world like that fiscal policy makes a big difference. I also hesitate to rely on anonymous sources for my arguments, but I sometimes hear from people on the Fed staff and the complaints always point in the direction of saying I should complain less about Fed inaction and more about fiscal policy.
I’m not quite sure what Matt is claiming here. If the Fed adjusts the fed funds target in such a way as to implement inflation targeting, NGDP targeting, or the Taylor Rule, then fiscal policy has no impact on demand. Perhaps Yglesias means that since 2008 they have been pegging short term rates near zero. But it’s also true that since 2008 the Fed doesn’t operate primarily by targeting interest rates, it operates primarily by using various unconventional monetary tools, including QE1, QE2, promises of low rates for varying periods of time, and Operation Twist. They seem to alternate between periods of aggressiveness and passivity. And although it’s hard to tell exactly, they still seem to be engaged in targeting some sort of proxy for demand (such as inflation.)
Now in fairness to Yglesias, their implicit target does seem lower than in normal times. I agree with those who say that if the Fed could cut nominal rates right now, it would do so. So the move toward unconventional policies has effectively created a more hawkish Fed. And I even agree with those who say Bernanke would like a bit more demand, especially if delivered by fiscal stimulus. So it’s possible that fiscal stimulus would work.
But when I look at what the Fed has actually been doing over the past three years, I have a really hard time writing down a set of implicit policy targets that allow for fiscal stimulus to play much of a role. I see them engage programs like QE2, when core inflation is too low, then see core inflation rising significantly, and then see the Fed disengage (i.e. tighten) as soon as they begin worrying that inflation is too high. And then when I see growth falter, I see the Fed promise two years of low rates, Operation Twist, and put out strong hints of more to come.
Unfortunately, the Fed seems to also respond to inflation that has no bearing on optimal monetary policy (such as oil prices increases produced by Libya and China.) I think Keynesians are failing to embed their vision of fiscal stimulus into the Fed reaction function that we actually observe, for levels of political stimulus that are politically plausible.
I don’t doubt that a WWII-style military build-up would more than offset Fed policy conservatism. But what about politically plausible stimulus, say another $400 billion? I see the most likely outcome as a modest boost to the economy, which pushes up oil prices and headline inflation, which frightens the Fed, which leads the Fed to refrain from addition conventional stimulus that they would otherwise do.
How do I know that the Fed would otherwise do more monetary stimulus? I don’t, but that’s certainly been their pattern over recent years, whenever the economy faltered. And there are already rumblings of the possibility of additional stimulus. And the number of hawks on the FOMC drops from 3 to 1 in January.
None of this means I’m right–as I’m no mind-reader. But if you look at how the Fed actually behaves, rather than what Bernanke says or “really” believes, then you are forced to conclude that the 2009 stimulus was sabotaged. That stimulus was not enough to create a robust recovery, even with unconventional Fed moves. If they hadn’t done that stimulus, it looks like the Fed would have done a more aggressive stimulus, as they seem determined to keep core inflation in the 0.6% to 2.0% range. And thus if we’d never done the 2009 fiscal stimulus, we’d probably be about where we are now–9.1% unemployment and 2% core inflation. But with a much smaller national debt.
Why do people have trouble accepting my view? Because at first glance it doesn’t seem to make sense. Bernanke seems like a good guy, doing his best. And he probably is. He keeps assuring us not to worry, that the Fed has plenty of ammunition. He keeps assuring us that the Fed will act forcefully to prevent deflation. This means that he is basically assuring us (whether he knows it or not) that if we have fiscal austerity the Fed will act much more aggressively, and use its unlimited ammunition to prevent deflation. You might ask; “what’s wrong with that?” Isn’t it the Fed’s duty to act aggressively if we are in danger of deflation? Yes, but the problem isn’t so much that he would take these aggressive steps if the fiscal authorities fail us, but rather that he won’t take these aggressive steps if the fiscal authorities don’t fail us. When you put these two statements together, you are led inexorably to the conclusion that the Fed will have tighter policy without fiscal stimulus than with it. And as a matter of pure logic, that means the Fed is at least partially sabotaging fiscal policy–even though I have little doubt that they don’t think of it that way.
A few final comments:
1. I’ve never denied that fiscal stimulus might work. One can always construct “God of the gaps” arguments.
2. Matt Yglesias also said:
I know that before the crisis, Sumner reached the conclusion that this was how fiscal and monetary policy would interplay.
It would be more accurate to say that a zero fiscal multiplier was the standard view of mainstream new Keynesian economists before this crisis.
3. Some types of fiscal stimulus can work with an inflation targeting central bank–for instance an employer-side payroll tax cut. I’ve advocated that sort of fiscal stimulus.
4. If a Fed official ever said to me what he apparently told Matt in a face to face conversation, I’d . . . well, I probably shouldn’t say what I’d do. I don’t want to sound like Rick Perry.