Our Fiscal Future

For John, BLUF:  The current debate over the "Fiscal Cliff", or Sequestration, is very important to our economic future.  But, after the Congress and Administration cobble together a system, and put a fig leaf over it, we will still not be out of the woods.  Good luck to us.

The Federal Reserve System consists of 12 Regional Federal Reserve Banks, one of which is in Richmond, Virginia.♠  The Richmond Bank, this December, issued a report titled A Citizen’s Guide to Unconventional Monetary Policy (December 2012, EB12-12).  The authors are Renee Haltom and Alexander L. Wolman.♥  Here is an an introduction to the paper:

Historically, the Federal Reserve’s primary monetary policy tool has been the federal funds rate.  Since pushing that rate as low as it can effectively go in December 2008, the Fed has turned to alternative policy tools to stimulate economic growth and keep inflation near 2 percent.  This Economic Brief provides a non-technical guide to how these unconventional policy tools are intended to work and discusses some of their risks.

Note that the Fed sees a 2% annual rate of inflation as not only aceptable, but actually a good thing.  Maybe they are concerned that we will fall into the economic stagnation that has inflicted Japan for the last decade.

One of the new tools is "Forward Guidance" or the stating of what is expected to happen in the future.  This Forward Guidance, or FG, is issued by the Fed's Federal Open Market Committee (FOMC).

Here is a key paragraph from the report:

A final and quite different risk is that FG could contribute to a steady state in which inflation is too low.  In the long run, nominal interest rates and inflation move together.  This is the “Fisher effect,” named after the late American economist Irving Fisher.  If a central bank commits to low interest rates for a very long period of time, it is possible that expectations would settle on a long-run deflationary equilibrium.  This possibility was raised in a 2010 speech by Minneapolis Fed President Narayana Kocherlakota, although he emphasized that he thought it highly unlikely to unfold in practice.  We do not have experience with long periods of forward guidance.  However, Japan’s experience of essentially zero nominal rates and intermittent deflation—a situation that has persisted for more than a decade—provides good reason to consider all the possible implications of extended forward guidance.

It isn't just the actions of Congress that will impact our economy.  It is also the Federal Reserve, and there are questions as to if the Fed has exhausted its ability to play its part.  Righting the economy is a complicated business.  I worry the team in DC may not be up to it.

Regards  —  Cliff

♠  The Chairman of the Kansas City Federal Bank was former Republican Primary Candidate Herman Cain.
♥  Renee Haltom is a writer and Alexander L. Wolman is an economist and vice president in the Research Department of the Federal Reserve Bank of Richmond.  Views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.