If we go off the fiscal cliff, the Fed can’t save us

December 5, 2012

With the negotiations to prevent an austerity crisis from beginning on Jan. 1 showing little evident progress, there is an inevitable question: If we go over the fiscal cliff, can Ben Bernanke and the Federal Reserve save the economy?

The answers shouldn't give much solace to policymakers on Capitol Hill and in the Obama administration.

Seriously, guys, I can't solve this. (Jeffrey MacMillan/Capital Business)

For a variety of reasons, monetary policy is not well suited to address the kind of economic challenge that would likely result from the tax hikes and spending cuts scheduled to take place at the start of 2013—and that’s not to mention that the Fed’s powers to combat economic weakness may be exhausted after five years of fighting financial crisis and its sluggish aftermath.

Fed leaders generally take the fiscal policy that emerges from Congress as a given, something largely beyond the central bank’s control, like hurricanes and oil prices. They then try to set a monetary policy that will create stable prices and low unemployment given the state of tax and spending policy and everything else they know about the economy. In a vacuum, that means that when Congress is cutting the deficit, whether by slashing spending or raising taxes, the Fed would tend to push toward easier monetary policy to try to offset the effect and keep the economy growing in the face of austerity.

That becomes problematic in the plausible scenarios that could emerge from the fiscal cliff.

If we go over the cliff and there is an austerity crisis, it will most likely be only for a limited period—perhaps a few days or weeks, and probably not more than three months, before being reversed. But monetary policy from the Fed doesn’t affect the economy immediately; instead it works with a “long and variable lag,” as the textbooks say, of perhaps six to nine months. Which means that if the Fed were to try to ease monetary policy in reaction to a fiscal-cliff induced panic, by the time the policy change had much effect, Congress may well have resolved the matter and the drag on the economy from fiscal policy could be no more.

A related problem is that in those early days of an austerity crisis, it will be hard to judge what, if any, lasting economic impact there will be. The Fed’s policy making committee isn’t scheduled to meet until Jan. 29-30, and it may not be clear yet how much economic damage there has been from a sudden onset of austerity. The Federal Open Market Committee will be acting without having seen a single monthly jobs report, or January numbers on retail sales or industrial production or any of the other many indicators they usually look to to guide their decisions. The Fed is not an institution that is inclined to make any major interest rate decisions based only on fragmentary information.

But even if Fed leaders did decide they needed to try to offset economic damage from the fiscal cliff—such as if it appeared that the austerity that went into effect Jan. 1 was poised to last indefinitely, prompting a recession—their options are more limited than usual. The Fed has already maintained its short-term interest rate target at zero for four years and counting, bought more than $2 trillion in Treasury bonds, and pledged to keep easy money policies in place for a time even after the economy begins improving. It is likely to decide continue with bond purchases, into 2013, at an FOMC meeting next week.

There are some policies that the Fed could undertake after a cliff-induced austerity that might help the economy on the margins, like agreeing to specific numerical thresholds for unemployment and inflation that would prompt it to consider ending easy money policies, or lowering the 0.25 percent interest rate paid on bank reserves parked at the Fed. But if Fed leaders thought that either of those would have tremendous benefits for the economy, they would have already taken them.

It would probably take truly dire circumstances for the Fed to seriously consider more extreme efforts to ease policy, such as setting an official target for nominal GDP, or using emergency lending authorities to buy corporate debt and other assets that the central bank is normally forbidden from buying.

In other words: The Fed has done pretty much everything it thinks it can do, at least in a non-crisis situation, to try to combat the weak economy.

“If the fiscal cliff isn’t addressed,” Bernanke said at a news conference in September, “I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.”

Put it all together, and Congress and the Obama administration probably shouldn’t be looking to the Fed’s Eccles Building on Constitution Avenue for protection from the ill-effects if they can’t reach a deal.

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Dylan Matthews | December 5, 2012