The Fed and the Fiscal Cliff

Ryan Avent has an ambitious post, in which he claims the Federal Reserve will resist proclaiming it has the tools to offset the fiscal cliff, should it even occur:

The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path.  It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.

The Fed will almost certainly not do this.

Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy…

I understand where Avent is going with this.  The Fed should be concerned that Congress will never get its act together if the Fed is always there to bail them out.  But reading the comments by Minneapolis Federal Reserve President Narayana Kocherlakota today makes me think his concerns are at least for the moment misplaced.

From the Chicago Tribune:

The U.S. Federal Reserve, which has kept short-term rates near zero since December 2008, may need to ease monetary policy further if U.S. unemployment rises or inflation falls, a top Fed official said on Wednesday.

Those are possible outcomes if U.S. lawmakers allow a raft of tax breaks to expire on schedule at the end of the year, pushing the nation over a “fiscal cliff” in 2013, Minneapolis Fed President Narayana Kocherlakota said in answer to an audience question after a talk at the Black Hills Knowledge Network.

But, he added, “I don’t see that that is a policy choice that the Congress and President wind up making,” he said.

That sounds to me like a pretty explicit promise to step up if Congress falls down on the job.  Likewise, St. Louis Federal Reserve President James Bullard, via Reuters:

“If there was a sharp slowdown in the U.S. I do think we’d have further scope to take action, we’d be taking on more risk, but we could do it if the situation called for it,” he said.

I take this to implicitly include a fiscal cliff slowdown.  So it seems to me that at least some monetary policymakers are already promising, explicitly or implicitly, to offset the fiscal cliff.

My guess is that in a low-inflation environment, monetary policymakers would have little reason to engage in moral hazard games, in that any hesitation on their parts would not be credible.  It seems pretty likely they would step on the monetary gas, even if doing so allowed Congress another year of reckless behavior.  Not doing so would be a clear violation of the dual-mandate. As such, are they really able to play coy?

Whether they accurately gauge the impact of the fiscal cliff and engage in the appropriate degree of easing, however, is another matter entirely.

• Become A Funded Futures Trader