Monetary Offset Isn't Really A Choice, It's Built Into Policy

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James Alexander directed me to a very good Bloomberg article on "monetary offset":

Federal Reserve Chair Janet Yellen may well be thinking it. Jeffrey Lacker, president of the Richmond Fed, came close to saying it. "A more stimulative fiscal outlook usually warrants higher policy rates," Lacker said a week after Donald Trump won the presidency. Translation: Trump's plans to stimulate economic growth could inspire the Fed to move in the opposite direction. Such a move, which would put the U.S. president and its central bank at odds, is called a monetary offset.

In my view, monetary offset is less discretionary than most people assume. Of course in a literal sense the title of this post is wrong, the Fed can choose to engage in monetary offset, or not choose to. But in a deeper sense I don't really think they have much choice.

Right now the Fed has a very impressive economic research apparatus, which models the economy under alternative monetary policy options. FOMC members then produce forecasts of inflation under "appropriate monetary policy". When you look two years out, the Fed's inflation forecast is generally about 2%. That's because the Fed's inflation target is 2%, and they wish to set policy at a level where they achieve this target. An exception might occur during a deep slump like 2009, where the Fed might believe that it will take a bit more than 2 years to get back to 2% inflation. But of course that's not where we are today.

As long as the Fed decides policy using this deliberative procedure, monetary policy is somewhat automatic, or at least less discretionary than most people assume from looking at the FOMC ponder over rate changes. And this means that as long as they continually set the fed funds target at a level expected to produce 2% inflation a couple years in the future, they will be automatically adjusting interest rates to completely offset the demand-side effects of fiscal stimulus (of course supply-side effects are another story.)

How would we know if the Fed had decided not to sterilize the impact of fiscal stimulus from the Trump administration? The answer is simple, you'd see the Fed's 2018 inflation forecast rise to 2.5%, or 3%. But that's not what we see, and I think it's very unlikely that we will see this sort of inflation forecast in the near future. If they didn't raise the inflation target during the recession (when it would have been helpful for growth) why would they raise it now?

Perhaps people are confused about this because they think in terms of stimulus being aimed at boosting growth, not inflation. Since the Fed has no mandate to restrict growth, why would it offset fiscal stimulus? But the direct effect of fiscal stimulus is to boost NGDP, and any further impact on RGDP depends on the slope of the short run AS curve. (Or the Phillips curve, if you prefer.) Even some economists appear confused on this point. Here's Simon Wren-Lewis, discussing empirical studies of monetary offset:

As far as I know, no one had expressed a concern about fiscal austerity because of the impact this will have on nominal GDP. The issue is always the impact on real activity, for reasons that are obvious enough.

Here Wren-Lewis confuses the ultimate goal with the direct effect. Real GDP can rise for many reasons, including demand and supply-side shocks. Keynesian stimulus is generally assumed to work through demand-side effects, which means that both growth and inflation should rise if stimulus is boosting demand. If you see growth rise but no change in NGDP, then the cause of the growth is obviously not "more spending" it's an increase in the incentive to work, invest and innovate. That sort of growth would not validate the theories of John Maynard Keynes; it would validate the theories of Arthur Laffer.

Here's how Nick Rowe responded to Wren-Lewis:

I disagree on the NGDP vs RGDP thing. Sure, RGDP is what we care about, but we don't know whether a rightward shift in the AD curve will cause increased RGDP, increased price level, or (more likely) some mixture of the two. Using NGDP instead of RGDP is a crude way of acknowledging our ignorance about the slope of the Short Run Phillips Curve.

Now, if fiscal loosening (in countries with flexible exchange rates) causes RGDP to increase but does not cause NGDP to increase, which is what your results and Mark's [Sadowski] results seem to imply, when taken together, we have a very uncomfortable conclusion for all of us. It tells us that the Short Run Phillips Curve slopes the wrong way. It tells us that an expansionary fiscal policy causes inflation to *fall*. Which is a very strange result indeed, unless you want to talk about the supply-side benefits of bigger deficit spending.

Now the supply-side argument is not stupid. If you suddenly lay off thousands of government workers, that causes some real supply side issues, because those workers won't be able to reallocate instantly even if aggregate demand does not fall. The search theorists do have some sort of a point. Any sort of change in the composition of demand between private and government sectors, in either direction, will cause some temporary increase in frictional unemployment, shifting the SRPC in the bad direction.

I don't find my above "explanation" fully convincing. But it's better than assuming the SRPC slopes the wrong way, so that an expansionary fiscal (or monetary) policy *reduces* inflation in the short run.

I agree. But an even simpler explanation is that tax increases reduce output in exactly the way predicted by Art Laffer.

I'm not an enthusiastic supply-sider like Laffer or Larry Kudlow, but even a moderate supply-sider like me would predict some negative growth effects from tax increases.

To summarize, Wren-Lewis thought he was testing the Keynesian model, whereas it was actually a test of whether Keynesian or supply-side models are correct. His results suggest that the basic demand-based Keynesian model is wrong and the supply-side model is right.

PS. New Keynesian models actually do allow for some supply-side effects. Thus if you spend a lot on military goods, then workers will feel poorer, and therefore they will wish to work harder to maintain their living standards. Obviously this is not the sort of transmission mechanism that people like Paul Krugman and Wren-Lewis have in mind when advocating fiscal stimulus.

Originally published on EconLog

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