JACKSON HOLE, Wyo. - A coming "era of fiscal stress" will make it difficult for central banks to control inflation unless steps are taken to curb deficit and entitlement spending, participants in the Kansas City Federal Reserve Bank's annual symposium were warned Saturday.
Just as the Fed and other central banks seek to "anchor" inflation expectations, fiscal expectations need to be better anchored if high inflation is to be avoided, argues Indiana University Professor Eric Leeper in a paper presented to a conference that includes Fed Chairman Ben Bernanke, a host of other Fed officials and prominent foreign central bankers.
Part of the problem, according to Leeper, is that fiscal policy is overly political. He likens it to "alchemy," whereas he says monetary policy is more of a "science." Fiscal policy needs to become more scientific and be better coordinated with monetary policy.
And Leeper encourages central bank chiefs to speak out more forcefully about the direction fiscal policy should take.
Whether or not they are coordinated, "monetary and fiscal policies are intrinsically intertwined and their distinct impacts are difficult to disentangle," he writes.
In some ways, fiscal policy is a "more powerful" and flexible tool than monetary policy, says Leeper. Yet, "monetary policy has scientific ambitions, while fiscal policy is mired in pre-science."
In normal times, this doesn't matter much to central banks, but "normal times may be nearing their end," he writes, noting that the International Monetary Fund has estimated that the net present value impact of deficits of aging-related government spending averaged across the advanced G-20 countries is over 400 percent of GDP. And the long-term budget imbalance associated with Social Security and Medicare in the United States this year is over $75 trillion in present value.
"These numbers portend an extended era of fiscal stress," Leeper writes. And that means trouble for the Fed and other central banks.
"Problems for central banks become far more pressing during periods of fiscal stress," he says. "Combined with fiscal alchemy, fiscal stress threatens to undermine the advances made by monetary policy."
"Threats do not arise only from insufficient resolve by central bankers to control inflation," Leeper continues. "Threats arise from unanchored fiscal expectations that can make it difficult or impossible for central banks to control inflation, regardless of the central bankers' resolve."
Fiscal expectations are "unanchored" when markets and the public do not know the size of future deficits and government borrowing requirements. For example, at the moment, there is uncertainty about whether or not the Bush tax cuts will be extended, and there is even greater long-term uncertainty about the ability or willingness of the federal government to curb rapid growth in entitlements and other spending programs.
That presents a huge challenge to central banks, Leeper contends.
"It turns out that the central bank's ability to control and target inflation rests fundamentally on fiscal behavior and people's expectations of fiscal behavior," he writes.
"When those expectations center on the appropriate fiscal behavior, the central bank can control inflation in the usual way," he goes on. "But when fiscal expectations are anchored elsewhere, it's quite possible that monetary policy can no longer do its job controlling inflation and stabilizing real activity."
"In the coming era of fiscal stress with no of credible government plans to confront the growing fiscal strains, unanchored fiscal expectations become a certainty," he adds.
Leeper warns that "fiscal stresses will rise around the world in the coming years and, if they remain unresolved, the likelihood of still worse economic outcomes rises commensurately."
Governments cannot simply rely on their central banks to keep inflation under control if they are running large deficits, he argues. "If monetary policy is to successfully control inflation, then fiscal policy must do much of the heavy lifting, freeing monetary policy to pursue that objective."
Complicating the picture, Leeper warns that some advanced countries are approaching their "fiscal limit" -- the point at which "fiscal policy can no longer adjust to stabilize debt."
In this climate, Leeper advises central bankers to "break the taboo against saying anything substantive about fiscal policy and, instead, to talk precisely and forcefully about how unresolved fiscal stresses can make it difficult or impossible for monetary policy to do its job."
He does not believe, however, that central bankers should give legislatures specific advice on tax and spending programs. Former Fed Chairman Alan Greenspan was often criticized for giving too much fiscal policy advice, and successor Bernanke has been much more reticent.
Leeper has a low opinion of U.S. government forecasts' of its own budgets, remarking that the Congressional Budget Office's "projections do little to help people form expectations over future fiscal policies." Pointing to multiple interpretations of the CBO's 2009-10 projections, he writes, "While this might be useful politics, it is not helpful economics and it does not constitute science."
He is also skeptical of "multipliers" -- the estimated impact of fiscal stimulus on GDP. Those estimates are "all over the map," he says.
Leeper's main focus is on the interacton of monetary and fiscal policy. Although it has been said by late Nobel Prize winner Milton Friedman, among others, that inflation is "a monetary phenomenon," in reality fiscal policy has a big role to play, he argues.
The "dirty little secret," he says, is that "for monetary policy to successfully control inflation, fiscal policy must behave in a particular, circumscribed manner."
In normal times, monetary policy has the responsibility of "providing a nominal anchor -- inflation," while fiscal policy plays "the role of providing a real anchor -- the real value of government debt," Leeper writes. "Because fiscal policy is assigned to stabilize debt, monetary policy is free to target inflation."
"If monetary policy is attending to inflation targeting, then fiscal policy must handle debt targeting by adjusting taxes enough to achieve the debt target," he writes. "When an increase in debt induces taxes to rise by more than the real interest rate, future taxes are assured to be sufficient both to service the new debt and to eventually retire debt back to target."
In this so-called "passive" fiscal policy scenario, "fiscal policy is doing the heavy lifting by ensuring that higher debt-financed transfers today create the expectation of higher taxes in the future," Leeper writes. "Those higher taxes are just sufficient to gradually retire debt back to target, eliminating the wealth effect of the higher transfers and relieving the pressure on inflation to rise."
Fiscal policies are deemed "passive" in the sense that the tax authority has limited discretion; in the face of rising government debt taxes must be raised. But as Leeper points out, "this does not always happen. Sometimes political factors -- such as the desire to seek reelection -- prevent taxes from rising as needed to stabilize debt."
If taxes do not rise to pay for increasing debt or if spending is not reduced, a different, more inflationary scenario can emerge, he warns.
"An expectation that transfers (transfer payments) will rise in the future reduces the household's assessment of the value of the government debt they hold," he explains. "Households can shed debt only by converting it into demand for consumption goods; hence, the increase in aggregate demand that leads to higher prices."
"In the current policy mix, a higher nominal interest rate raises the interest payments the household receives on the government bonds it holds," he goes on. "Higher nominal interest receipts, with no higher anticipated taxes, raise household wealth and trigger the same adjustments (in consumer spending). In this sense, ... monetary policy has lost control of inflation."
"When agents believe that at times fiscal policy will not respond systematically to stabilize debt, then ... monetary policy's ability to control inflation will be curtailed," he warns.
"Heading into an era of fiscal stress, as many advanced economies are, it may be reasonable for individuals to ascribe some probability to a future fiscal regime in which fiscal policy is no longer able or willing to target government debt," he adds. "And the longer that governments delay making the fiscal reforms that will anchor expectations on the fiscal behavior ... the more likely it is that central banks will be unable to control inflation."
Bringing the interaction of monetary and fiscal policy closer to home, Leeper talks about the current and prospective configuration of Fed policy and Obama administration policy.
"So far the Federal Reserve has signaled its willingness to continue its passive behavior by keeping the federal funds rate low," he writes. "Eventually, though, as the recovery gains strength and inflation picks up, it is likely that the Fed will return to its usual active policy stance."
"In the absence of a coordinated switch in fiscal policy to a passive stance, both policies would be active, at least for a time," he continues. "If regime were permanent and both policies were active, debt would explode and there would be no equilibrium."
"Doubly active policies mean that no one is attending to debt stabilization and this produces markedly different paths for macro variables ... : inflation rises and remains well above its initial level; output and consumption boom even though the real interest rate rises; government debt grows with no tendency to stabilize."
Leeper says this prospect "should be disturbing to central bankers. A switch in monetary policy to fighting inflation is doomed to failure if fiscal policy does not simultaneously switch to raising taxes to stabilize debt. Although the economy experiences a boom, it does so by generating chronically higher inflation and a growing ratio of government debt to GDP."
Policymakers face a grim set of choices in what Leeper calls "the coming era of fiscal stress." He notes that Social Security, Medicare, and Medicaid "are projected to grow exponentially" and that the federal government's share in GDP almost doubles over the projection period: from an average of about 18% in 1962 to between 31% and 35% in 2083, excluding interest payments on outstanding debt.
State and local fiscal crises add to the prospective debt burdens, "raising the likelihood of a federal government bailout of defaulting states," he warns. "Greece's recent experience may portend U.S. events."
As bad as the U.S. fiscal situation is, other countries, including Canada and Korea, are even worse, he says.
For now, the fact that investors in U.S. debt are still "happily buying federal government bonds" means "they must believe that in the long run, policies are sustainable because current policies will not remain in effect," Leeper writes.
But he goes on to warn of a looming "fiscal limit" -- an upper limit on how much tax revenue can be raised and a lower limit on the level of government spending.
"If a country is approaching its fiscal limit, then it no longer has the fiscal flexibility to adjust surpluses to stabilize debt," Leeper says. "But (a regime) in which monetary policy targets inflation and fiscal policy targets real debt, requires fiscal flexibility, so fiscal limits can undermine the efforts of inflation targeting central banks to accomplish their prime objective."
"The more likely people believe it is that the limit will be reached, the harder it will be for central banks to retain control of inflation," he adds.
Leeper maintains that the U.S. is "well below" its "fiscal limit" in the sense that it has more room to raise taxes than nations in Europe with much higher tax rates. There is less room to cut spending, he says, although that is a political choice.
Among the forces that could impact growth and inflation and in turn monetary policy in coming years, Leeper lists an extension of the Bush tax cuts; potential deficit cuts, bail-outs of state governments; expenditures on bankrupt government-held Fannie Mae and Freddie Mac, and a reversal of the Greece-related "flight to quality" that has swelled demand for U.S. government debt.
Leeper says these are "the types of news that could cause significant revaluations of government debt, with resulting impacts on inflation rates and real activity."
"Most of these examples would not even generate a flutter in inflation during normal times when other fiscal adjustments can be made to offset their impacts on the value of debt," he says. "But in times of fiscal stress, when people's expectations of fiscal policies are unanchored and susceptible to wide swings, they could cause important shifts in aggregate demand to which central banks may be tempted to respond."
"To determine whether a monetary policy response is appropriate, central banks need to have a firm understanding of all the potential sources of the demand fluctuations," he cautions.
Although some have expressed fear of hyperinflation, Leeper says, "the reason that high inflation is a low-probability event is because people believe that some entitlements reform is quite likely in the future."
However, he warns, "Policymakers who use the low probability of high inflation as a justification for inaction will change people's beliefs about future policies and convert high inflation into a far more likely outcome."
Leeper also warns central banks against overreacting to an updrift of inflation if it is caused by perceptions that the government will be unable or unwilling to stabilize its debt.
"Central banks might reasonably react to the scare by preemptively tightening policy, which may slow the economy but will do little to combat the incipient inflation, which is driven by fiscal factors outside the central bank's control," he writes. "It will be important for central bankers who wish to keep inflation low and stable to understand the subtle ways that fiscal stress can affect the macro economy."
Arguing for the development of a fiscal "science," Leeper poses a number of questions that economists need to ask:
1. Are there circumstances under which deficits (surpluses) should be permitted to permanently raise (lower) the debt-GDP ratio or should debt always be retired back to some long-run target?
2. Should there be a long-run target for debt? What should it be?
3. Should government spending, taxes, and monetary policy be adjusted to stabilize debt?
4. How rapidly should debt be retired back to target?
5. What are the macroeconomic effects of certain government spending and tax changes in well-specified thought experiments?
6. What are a country's fiscal limits and how much government debt can it support before markets deem the debt to be risky?
7. Are there times when monetary policy should support bond prices and maintain the value of debt? What are those times?
8. Should monetary and fiscal policy behave in fundamentally different ways in an era of fiscal stress than they do in normal times?
Though much of his 56-page paper deals with inflation, Leeper closes by dealing with recently concerns about possible deflation.
"Chairman Bernanke has suggested that if those worries intensify, the Fed is prepared to take further policy actions," he notes before asking, "Where is fiscal policy in this conversation?"
There are "ways in which fiscal policy can contribute to combating deflation, particularly when the central bank's interest rate instrument has fallen as far as it can," he writes. "Those ways entail current fiscal expansion that brings no immediate prospect of higher future surpluses or news that surpluses will be lower in the future."
But Leeper observes that "fiscal news in the United States lately is all about plans to raise future surpluses. U.S. fiscal policy, like its European counterparts, is too busy flip-flopping to be a player."
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