NEW YORK – The Federal Reserve’s ability to accomplish its dual mandate could be “undermined” by blurring the lines between monetary, fiscal and credit policy, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said Friday.
“Monetary policy should not be used to solve a fiscal crisis,” he told the Monetary Policy Forum, according to prepared text of his speech, which was released by the Fed. “The ability of the central bank to maintain price stability can also be undermined when the central bank itself ventures into the realm of fiscal policy,” Plosser said.
In Europe and the U.S., government deficits resulted from fiscal policy decision-makers “knew would be unsustainable in the long run,” leaving financial markets “skeptical about whether the political process can come to grips with the problems.”
Instead of action, lawmakers “engage in protracted debates” about how to right the apple cart and who will bear the burden of costs. “In my view, these prolonged debates impede economic growth, in part, due to the uncertainty they impose on consumers and businesses,” Plosser said. “Moreover, the longer the delay in developing credible plans, the more costly it becomes for the respective economies.”
And, he noted, the decision of how to restore fiscal discipline “will have profound implications for years to come,” he said. Hard decisions between added taxes or service reductions must be made, and until there is a plan, “uncertainty encourages firms to defer hiring and investment decisions and complicates the financial planning of individuals and businesses. 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 noted.
Governments have ignored underlying trends causing unsustainable fiscal deficits, in U.S., for example, federal entitlements such as health care and Social Security, he said. “The financial crisis and recession have simply exacerbated the underlying problems and perhaps moved up the day of reckoning.”
Of course, the fiscal challenges can have “profound implications for monetary policy and the role of central banks,” Plosser said.
Since governments have the option of taxing, issuing debt, or printing money to pay bills, “monetary and fiscal policy are intertwined through the government budget constraint,” Plosser added. However, “separation between the functions and responsibilities of central banks and those of the fiscal authorities” remains more than a good idea since having the Fed involved in fiscal policy undermines its ability to do its job, he said.
Central banks were established to be independent so governments wouldn’t be tempted to print money, and create inflation, to defeat budgetary stresses. However, Plosser warned, central banks must avoid engaging in fiscal policy or actions that “distort private markets.”
He suggested three ways to help central banks steer clear of fiscal policy: giving it a narrow mandate, such as price stability; restrict the type of assets it can hold on its balance sheet; and limit its discretion by setting a system or rules.
“Unfortunately, over the past few years, the combination of a financial crisis and sustained fiscal imbalances has led to a substantial breakdown in the institutional framework and the accepted barriers between monetary and fiscal policy,” Plosser said. The pressure has come from both sides. Governments are pushing central banks to exceed their monetary boundaries and central banks are stepping into areas not previously viewed as acceptable for an independent central bank.”
One example is the call for central banks to abandon their commitment to stable prices and create “higher inflation to devalue outstanding nominal government and private debt,” a move to which Plosser objects. “In my view, inflation is a blunt and inappropriate instrument for assigning winners and losers from profligate fiscal policy or excessive borrowing by private individuals and firms. Forced redistributions of this kind, if undertaken at all, should be done through the political process and by the fiscal authorities, not through the backdoor by the central bank by way of inflationist policies.”
Such policy is “nothing more than a call for debt monetization to solve a problem that is fundamentally fiscal in nature.”
Calling the Fed a “lender of last resort” to governments, allowing it to take fiscal action “is a strained argument at best,” Plosser said. A lender of last resort provides “liquidity to financial institutions that are solvent but facing temporary liquidity problems.”
But, that merely conceals a monetizing sovereign debt of “countries that are insolvent due to their inability to manage their fiscal affairs,” he said. “Monetary policy should not be used to solve a fiscal crisis.”
The fault also lies with central banks, which have “undertaken actions that have blurred the distinction between monetary policy, credit policy, and fiscal policy,” he said. This includes creation of credit facilities to support particular asset classes. “These steps were undertaken with the sincere belief that they were absolutely necessary to address the challenges posed by the financial crisis.”
He added, “I view the breakdown of the traditional institutional arrangements as dangerous and fraught with longer-term risks. 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.”
Once the line is crossed, the private sector, financial markets, or the government could pressure it to turn to its balance sheet in place of other fiscal decisions, and threaten its independence.
Saying he has “long argued for a bright line between monetary policy and fiscal policy, for the independence of the central bank, and for the central bank to have clear and transparent objectives,” Plosser suggested limiting “the Fed to an all-Treasuries portfolio, except for those assets held as collateral for traditional discount window operations. Should the fiscal authority ask the central bank to engage in lending outside of its normal operations, the fiscal authority should exchange government securities for the nongovernment assets that would accumulate on the central bank’s balance sheet as a result. This type of swap would ensure that the full authority and responsibility for fiscal matters remained with the Treasury and Congress and the Fed’s balance sheet remained essentially all Treasuries.
“Congress has mandated the goals of monetary policy to promote price stability, maximum employment, and moderate long-term interest rates. Asking monetary policy to take on ever more fiscal responsibilities undermines the discipline of the fiscal authorities and the independence of the central bank. Central banks and monetary policy are not and cannot be real solutions to the unsustainable fiscal paths many countries currently face,” he continued. “The only real answer rests with the fiscal authorities’ ability to develop credible commitments to sustainable fiscal paths. It is 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 and a weakening of fiscal discipline.”
