Fed's Plosser: Restore 'Bright Boundaries' Between Fiscal, Monetary Policy

Philadelphia Federal Reserve Bank President Charles Plosser warns of a "dangerous" breakdown in the traditional separation of monetary and fiscal policy and urges a restoration of "bright boundaries" between the two in an essay released Friday by his Bank.

Plosser, writing in the Philadelphia Fed's Annual Report, expresses concern that the Fed and other central banks will come under increasing pressure to "monetize" the "unsustainable" debts of their governments. He also urges the Fed and others to refrain from crossing the line and engaging in fiscal policy themselves.

Specifically, he repeats past calls on the Fed to stop buying mortgage backed securities, as it has been doing since last September at a $40 billion monthly pace. He contends this practice amounts to "credit allocation" and to a fiscal "subsidy" of some borrowers at the expense of others.

Plosser further argues that large budget deficits and mounting national debts and the political debates about how to address them "impede economic growth" because of the uncertainty they impose on consumers and businesses.

Among the questions bedeviling firms and households, he says, are: "Will there be higher taxes on investments by the private sector that risk reducing productive capacity and output in the future? Will there be higher taxes on labor that discourage work effort or hiring?"

"Until fiscal authorities choose a path, uncertainty encourages firms to defer hiring and investment decisions and complicates the financial planning of individuals and businesses," Plosser writes. "The longer it takes to reach a resolution on a credible, sustainable plan to reduce future deficits and limit the ratio of public debt to gross domestic product, or GDP, the more damage is done to the economy in the near term."

Plosser goes on to pose two types of problems, beginning with the pressure on central banks to help governments finance their deficits.

"In a world of fiat currency, central banks are generally assigned the responsibility for establishing and maintaining the value or purchasing power of the nation's monetary unit of account," he notes. "Yet, that task can be undermined or completely subverted if fiscal authorities independently set their budgets in a manner that ultimately requires the central bank to finance government expenditures with significant amounts of seigniorage in lieu of tax revenues or debt."

"Without the protections afforded by independence, the temptation of governments to exploit the printing press in the absence of fiscal discipline is just too great," he adds.

The Fed and other major central banks are committed to pursuing "price stability," but without citing examples, Plosser cites "calls in many countries to abandon this commitment and create higher inflation to devalue outstanding nominal government and private debt."

"As a monetary policymaker, I do not want to be complicit in such a strategy," he declares. "Moreover, history has shown that once inflation is unleashed, it is not always easy to bring it back down, especially if the central bank loses the public's confidence and damages the credibility of its commitment to price stability."

Plosser writes that "proposals to use inflation to fix the debt overhang problem are nothing more than a call for debt monetization to solve a problem that is fundamentally fiscal in nature."

Short of "printing press" finance, he says central banks are also coming under pressure to use their "lender-of-last-resort" function to aid failing firms, in lieu of direct aid from the government. He recalls the host of special financing facilities set up by the Fed, sometimes in cooperation with the U.S. Treasury, to assist individual firms and market segments.

"Such a call to widen the lender-of-last-resort role is a perversion of one of central banking's core concepts," Plosser asserts. "It is a fig leaf to conceal the process of monetizing the sovereign debt of those countries that are insolvent due to their inability to manage their fiscal affairs."

Plosser's other area of concern, as always, is the use of open market operations to ease certain industries, such as housing.

Taking aim at the MBS purchase program, he writes, "When the Fed engages in targeted credit programs that seek to alter the allocation of credit across markets, I believe it is engaging in fiscal policy and has breached the traditional boundaries established between the fiscal authorities and the central bank. Indeed, some of these actions have generated pointed criticisms of the Fed."

"I view the breakdown of the traditional institutional arrangements as dangerous and fraught with longer-term risks," he continues. "While it is popular to view such blurring of the boundaries as appropriate 'cooperation' or 'coordination' between the monetary and fiscal authorities, the boundaries were established for good reasons and we ignore them at our own peril."

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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