WASHINGTON - The Federal Reserve is better suited for stabilizing the economy against "aggregate shocks" than the fiscal authority, in part, because the political makeup of the fiscal authority is not well suited for the timely, subtle reactions necessary, St. Louis Federal Reserve President James Bullard argued in an economic paper released Friday.
Bullard also argues that the Fed's quantitative easing programs have been effective since interest rates hit the zero lower bound.
Bullard's paper, titled "Death of a Theory," says that it was widely accepted pre-2007 that stabilizing the economy in the short term should be left to the monetary authority.
However, after the Fed lowered interest rates between 0 and 25 basis points in 2008, the thought process changed, assuming that fiscal policy would be more effective for stabilizing the economy because the monetary authority could no longer target nominal interest rates.
Bullard argues that monetary policy can be effective at the zero lower bound because the Fed can still influence inflation expectations and that in practice, fiscal policy makers turned to the international debt markets, taking on burdensome debt to finance stimulative measures. He said these have been interpreted by the private sector as pushing taxes down the road, thereby offsetting the benefits.
Bullard said by realizing economic shocks should be handled by the monetary authority, while fiscal policy focuses on setting medium- and long-term tax and spending programs, the theory that fiscal policy is better suited to handle economic shocks is no longer true (the "death"). He added that the "conventional wisdom" in the preceding decades that stabilization policy should be left to the monetary authority is being reestablished.
"A key issue that immediately arose was whether monetary stabilization policy could still be conducted effectively at the zero lower bound on nominal interest rates," Bullard said.
"If it could, then there would be less need to move toward fiscal programs for stabilization, because the existing conventional wisdom -- 'leave it to monetary policy' -- would still be valid," Bullard said.
Bullard cited a 2002 speech by Fed Chairman Ben Bernanke in which he states "A principal message ... is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
Bullard also said "it seems obvious that existing political processes will not be of the type that can easily react in a timely and subtle way to macroeconomic shocks."
Rather, Bullard said fiscal policy should focus on tax and spending decisions that "should be set in a way that fosters maximum economic growth over the medium and longer run and that garners enough political consensus to remain stable over long periods of time."
Bullard argued that another problem with the belief fiscal policy is better suited for economic stabilization is the recent practice of fiscal policymakers tapping international debt markets.
He said in the recent crisis the practice has resulted in "too much debt" or the point when the temporary benefits of defaulting exactly offset the benefits of continuing to have access to the credit markets.
"To say that monetary stabilization policy cannot be effective once the zero lower bound has been encountered is to say that the central bank cannot create inflation once this condition is met," Bullard said, adding that instead he thinks the Fed has been able to influence inflation and inflation expectations.
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