Tuesday, April 26, 2011

Don't forget fiscal policy!

The most interesting aspect of this week’s FOMC meeting is the next instalment of the evolving debate about the timing and method of the withdrawal of the extraordinary monetary measures that were put in place during the GFC to support the US economy and (global) financial system.

There seems little doubt that QE2 will play out as scheduled, ending in June. That was unanimously agreed to at the last FOMC meeting and since then, economic data has been soft, leading to many economists revising down their Q1 2011 growth expectations (see post below). There therefore seems no need to change the QE2 plan so close to its natural conclusion.

But as we turn our minds to exiting the stimulus, it has amused me from time-to-time as some commentators have waxed lyrical about the success of Quantitative Easing. Hang on a minute - we’re only half-way through the experiment! Let’s reserve judgment until the full cycle of stimulus injection and withdrawal is complete.

The Fed has already outlined the tools at its disposal when the time comes. They include reverse repurchase agreements and the paying of interest on bank reserves. The key question is how effective these measures will be at preventing around US$1.4 trillion in excess bank reserves from stoking inflation in a gradually improving economic environment. This seems to me the far greater threat to inflation than the level of the Fed Funds rate.

Nevertheless some commentators are predicting a rise in the Fed Funds rate as early as late this year. I think that’s too early. I’m happy with current market pricing suggesting a rate rise in early 2012. In fact that expected tightening has shifted out slightly over the last couple of weeks from March to April 2012, no doubt reflecting the downward revisions to near-term growth and the quantum of cuts to the Budget deficit planned by both the Democrats and the Republicans over the next decade.

That is something worth keeping in mind as the stimulus withdrawal debate gathers momentum over the next few months: Fiscal policy will be a critical factor in all of this. We have become used, over the last two or three decades, to monetary policy being the only game in town. That’s the opposite of the 1930s when fiscal policy was the only policy instrument that mattered.

Over the next few years fiscal austerity as a result of large structural budget deficits SHOULD be a key factor in determining, and done right limiting, the level of interest rates. “Co-ordinated fiscal and monetary policy” will be the buzz-phrase of the next decade.