Why can’t the Fed just prevent the ‘fiscal cliff’?

Say at the end of 2012, Congress can’t strike a budget deal and we reach the dread “fiscal cliff.” Taxes go up, spending gets slashed. Would the U.S. economy fall into recession? The Congressional Budget Office sure thinks so. But Ryan Avent wonders why the Federal Reserve couldn’t just step in.

Don’t worry, Bernanke will catch you. (Behrouz Mehri - AFP/Getty Images) After all, he argues, the central bank’s whole job is to maintain demand in the economy even if there’s a large external shock — like a sharp rise in taxes and drop in spending. Propping up the economy would be tricky, he notes, since the Fed can’t really lower interest rates further. But what the Fed could do is influence expectations ahead of time, by announcing that the bank will take whatever steps necessary to maintain demand and avoid deflation. “[M]arkets know that it’s fruitless to bet against a determined central bank with a printing press,” Avent notes. And those expectations could prove self-sustaining.

Here’s how Avent thinks this should work in practice: “The Fed could therefore proclaim to the world that will maintain aggregate demand growth … at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility.”

But will the Fed actually take these steps? Avent argues that it probably won’t — because the Fed doesn’t want to give Congress incentives to pursue “reckless fiscal policy.” Over at Fed Watch, however, Tim Duy thinks that the Fed is already starting to hint that it will offset the fiscal cliff. Duy rounds up a few recent statements from members of the Federal Reserve Board saying that the central bank will try to boost the economy if it starts weakening again.

St. Louis Federal Reserve President James Bullard, for instance, recently said: “If there was a sharp slowdown in the U.S., I do think we’d have further scope to take action. We’d be taking on more risk, but we could do it if the situation called for it.”

Duy argues that the Fed really doesn’t have much choice but to start suggesting that they’ll offset the economic impact of any possible budget shock. “Not doing so would be a clear violation of the [Fed’s] dual mandate,” he notes. A bigger question, though, is whether the Fed actually can “accurately gauge the impact of the fiscal cliff and engage in the appropriate degree of easing.” Just because the Fed will try to ease the impact of Taxmaggedon doesn’t mean they’ll be able to do so perfectly.