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What The Fed Fears

SCOTT SUMNER and TIM DUY offer responses to yesterday’s post on monetary policy and the fiscal cliff that are worth a read. To summarise very briefly, Mr Sumner asks why the Fed wouldn’t be happy to fully accommodate a plunge over the fiscal cliff given the resulting improvement in the government’s budget position, and Mr Duy argues that members of the Federal Open Market Committee are already signalling that a dive off the fiscal cliff would be one of the events that might cause the Fed to take additional expansionary action. They both make reasonable points, so let me see if I can’t rephrase and clarify my argument.

First, if Congress fails to avert the fiscal cliff scenario, I am confident that the Fed will intervene and ease policy in order to dampen the blow to the economy. Mr Duy is not wrong.

Second, the Fed’s response will probably fail to offset entirely the impact of the cliff, because it will probably behave as it has in the recent past, reacting primarily to dangers of substantial disinflation. That will allow the cliff to have a serious impact on real output; the fiscal multiplier will be much higher than it ought to be.

Third, the Fed could behave differently by focusing on expectations. Essentially, it could begin arguing now that nothing Congress might do on fiscal policy poses a meaningful risk to the demand side of the economy. That’s not what it’s doing. It looks to me like it isn’t doing this because it honestly doesn’t want Congress to let this happen, and it may be worried that fear of economic disaster will be the only thing that might get Republicans and Democrats to arrive at an agreement to soften the fiscal blow.

The tricky thing to explain is why the Fed isn’t content to see a sudden fiscal tightening of 4% of GDP.

http://www.economist…5/fiscal-policy

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