NEW YORK – With its moves to end the fiscal crisis, the Federal Reserve “embarked on a path that has blurred the distinction between monetary policy and fiscal policy,” Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said Friday.
“Unfortunately, from my perspective, the Fed and other central banks have already embarked on a path that has blurred the distinction between monetary policy and fiscal policy, Plosser told the Philadelphia Fed Policy Forum, according to prepared text of his remarks, released by the Fed. “These steps were undertaken with the sincere belief that they were absolutely necessary to address the challenges posed by the financial crisis.”
He said attempts to do away with maintaining price stability result from “fiscal authorities” being “unable to make credible commitments to maintain fiscal discipline and because central banks have been willing to engage in actions that stray into the realm of fiscal policy … This is a disturbing trend that risks undermining the independence of the central bank to control monetary policy and its ability to preserve a credible commitment to price stability.”
Credit facilities set up to prop up certain asset classes, i.e., commercial paper and asset-backed securities, as well as mortgage-backeds, were the examples Plosser gave of the Fed inching into fiscal policy. “These types of credit programs target particular market sectors and thereby alter the allocation of credit across markets, reducing funding costs for some sectors and likely raising costs for others,” he said. “These programs departed from the usual way the Fed implements monetary policy through buying and selling U.S. Treasury securities, an activity that is generally neutral across markets. When the Fed engages in targeted credit programs that seek to change the allocation of credit across markets, I believe it is engaging in fiscal policy.”
Instead of targeting the specific asset classes for purchase, the government could have issued Treasury securities to back lending to the markets, as they do to aid the small business market and to subsidize home mortgages, he said. “Even the recent maturity extension program, or ‘Operation Twist’ as it is sometimes called, involves selling short-term Treasuries and buying longer-term Treasuries – an action that could just as well have been conducted by the U.S. Treasury,” Plosser argued.
“Once a central bank ventures into conducting fiscal policy, it may find itself under increasing pressure from the private sector, financial markets, or the government to use its balance sheet to substitute for other fiscal decisions,” he said. “This pressure can threaten the central bank’s independence in conducting monetary policy and thereby undermine monetary policy’s effectiveness in achieving price stability.”
By using the Fed to promote fiscal policy “undermines” the central bank’s ability to achieve its congressional mandate, Plosser said. “Central banks and monetary policy are not and cannot be real solutions to the unsustainable fiscal paths many countries currently face. Proponents who believe otherwise are skating on thin ice. The only real answer rests with the fiscal authorities and their ability to develop credible commitments to sustainable fiscal paths,” Plosser asserted. “It’s a difficult and painful task to be sure, but a monetary solution is a bridge to nowhere at best, and the road to perdition at worst – a world of rising and costly inflation.”
Inflation, he said, is not the answer. “The inflation tax would transfer wealth from those that have lent money to the government in good faith – the investors in sovereign debt – to the government itself. I am deeply skeptical of such a strategy. In my view, inflation is a blunt and inappropriate instrument for assigning winners and losers from profligate fiscal policy. 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 return to price stability,” he said. “The continuing fiscal disarray may also lead the public to believe that the government’s only near-term strategy is to monetize the debt. Even if the central bank resists, expectations of future inflation could become unanchored and inflation could rise through no fault or consequence of central bank action or intent.”
