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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is director of economics at the Budget Lab at Yale University and former chief economist at the White House Council of Economic Advisers
Budget scorekeeping typically is never top of mind for markets. To the extent markets track policy, central banks are usually king. Central bankers are followed with all the rapt attention of royalty.
By the same token, monetary policy is an afterthought in fiscal analysis. Conventional “budget scores” that analyse the impact of government spending don’t consider the Federal Reserve at all. And dynamic scores, which use models to incorporate macroeconomic feedback effects, usually demote the central bank to a single equation.
This is short-sighted. A new report by the Budget Lab at Yale University shows how the Fed plays an important, if indirect, role in how US fiscal policy will affect the economy in near future. In turn, this underlines how critical the Fed’s independence is.
It is common shorthand to speak of fiscal policies that seek to boost demand as “inflationary” when Congress enacts them while an economy is at full employment. To the extent a move like a tax cut or a spending increase adds to inflationary pressure by boosting demand, this description is accurate. But if the Fed anticipates this effect, and does its job well by tightening monetary policy, then the trade-off in the economy is not primarily increased inflation, but a temporarily higher interest rate that cools the demand shock. These higher rates then raise debt service costs for the government.
Economists often anticipate this sort of reaction in their forecasts. For example, when the Congressional Budget Office updated its economic projections in the wake of the Tax Cut and Jobs Act’s passage in 2017, its inflation outlook barely budged whereas its projection of the benchmark federal funds rate moved meaningfully higher.
But what if, under political pressure, the Fed chooses not to tighten at all? Then the trade-off of an expansionary fiscal policy would be entirely in the form of higher inflation.
Hence, political capture — the appointment of political loyalists or overt outside political pressure — is another important fiscal dimension to the Fed. Throughout its history, the Fed has not always maintained political independence. For example, President Richard Nixon pressured Fed chair Arthur Burns in the early 1970s to keep monetary policy easy during his re-election bid. Despite inflationary pressures building since the late 1960s, Burns acquiesced. When the 1973 oil crisis struck, these built-up excess demand pressures collided with the energy supply shock to produce the stagflation of the 1970s. Our research indicates that a politically captured Fed could once again quickly lose control over prices during significant economic shocks.
We conducted a macroeconomic experiment of a thousand simulations over the next six years, randomly applying positive and negative economic shocks that ranged between tiny and gigantic. We found that under a captured Fed, the typical outcome in our simulations was not disastrous: cumulative inflation over six years was only about a half percentage point higher compared with a non-captured Fed. However, in the worst-case scenarios where lots of inflationary economic shocks happened to hit, the 95th percentile outcome was a price level two percentage points higher under a captured Fed.
These results may also understate reality. The Fed’s model assumes that markets and consumers will continue to expect the central bank to keep delivering on its inflation goals in the future even when it repeatedly fails to deliver 2 per cent inflation. When we relax that assumption and allow people to “de-anchor” their inflation expectations — set them more directly on the inflation they observe rather than the Fed’s target — then the bad case scenario rises to a 5 per cent higher price level over six years for a captured Fed versus a non-captured one. That’s almost an extra point a year in inflation.
The upshot is that economists and budget analysts should pay close attention to their assumptions about the Fed in thinking about policy over the next few years. But there are broader implications too. We believe there is rising political risk in US markets that is likely being underpriced by markets. This can take many forms, but one is institutional capture, including the Fed. If the central bank lost independence, that would have profound implications for how future fiscal policy might impact the economy.
