New Findings On Fiscal Policy Give One More Reason Not To Fear Inflation

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by: Ed Dolan

Summary

Some economists have voiced fears that excessive tax cuts and spending increases, as the economy approaches full employment, could cause inflation.

New research from the Fed suggests that fear is overblown.

Findings show that the effects of expansionary fiscal policy are weakest when unemployment is low, as it now is in the United States.

As we wait for action the budget and tax reform, how much do we have to worry that Congressional missteps will bring a return of inflation? Not much, according to the latest research.

In an era when Congress seems to find it hard to get its act together, Americans have grown accustomed to seeing the Federal Reserve as the main agent of macroeconomic policy. The Fed's job, in this view, is to stimulate the economy with low interest rates when it falls into recession, and to forestall overheating with timely rate increases when expansion turns to boom. However, those of us who remember our Econ 101 know that, in theory at least, government spending and taxes matter, too. Congress can counteract the business cycle by moving the fiscal dial toward deficit during a recession and by imposing tax increases or spending cuts if an expansion threatens to become inflationary.

The problem is, Congress has not always done its job well. During the recessions of 2001 and 2008, it did approve expansionary tax and spending measures, but it has not consistently applied fiscal restraint before booms have gotten out of hand. If anything, it has often done the wrong thing at the wrong time. For example, tax cuts and increased military expenditures in the early years of the George W. Bush administration are often fingered as one of the causes of the housing bubble that triggered the Great Recession.

Some economists (myself included) have voiced concern that under the presidency of Donald Trump, fiscal policy is about to turn procyclical once again. Trump's preliminary budget contained proposals for tax cuts and spending increases that added up to a strong dose of fiscal expansion. Anything of the kind, we worried, could lead to a return of inflation and a new boom-bust cycle.

However, recent research by two Federal Reserve economists, Regis Barnichon and Christian Matthes, suggests there is less to fear than we thought. This research, summarized in an economic brief from the Richmond Fed, maintains that fiscal policy is asymmetrical in its effects. Contractionary fiscal policy has more effect than expansionary policy. Furthermore, expansionary policy has its greatest effect when unemployment is high, while contractionary policy has its greatest effects when unemployment is low.

The authors use the concept of the fiscal multiplier to gauge the impact of fiscal policy. Roughly speaking, the fiscal multiplier shows how much GDP will increase for each one dollar increase in federal spending or decrease in federal taxes. They report that the multiplier for contractionary policy ranges from about 1 when unemployment is 1 percentage point below its full employment level to about 2 when it is 2 percentage points above normal. Expansionary policy, in contrast, has a multiplier well below 1 even in a recession, and as little as 0.2 when unemployment is 2 points below normal.

The bottom line: Under current conditions, even if Congress were to slash taxes recklessly and spend lavishly on military upgrades and hurricane relief, it would add very little to the ongoing expansion. Unemployment would remain low, but acute labor shortages would be unlikely. Inflation would remain safely under control unless the Fed decided to add monetary fuel to the fire, which it shows no hint of doing.

So, panic not! Congress may dither, it may bust the budget, it may throw fiscal caution to the winds, but whatever it does, it is unlikely to trigger a burst of inflation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.