The Fed says it will tolerate more inflation, but won't create it. Congress should.
We do not live in normal times. There are lots of ways to tell, but the best one is that we can borrow for free for 20 years, adjusted for inflation. That's the market's way of begging us to borrow more, despite everything you may have heard about the fabled bond vigilantes who hate, just hate, the deficit. But it's not just markets that want us to take on more debt. Ben Bernanke does too. He told us right there in the Fed's latest economic projections.
In normal times, when interest rates are higher than zero, fiscal stimulus doesn't make much sense. Congress can cut taxes or increase spending to try to boost the economy, but the Federal Reserve will probably stand in its way. Why? Because the Fed has its inflation target, and the Fed cares very much about hitting it. If stimulus spending or tax cuts push inflation above the Fed's target, the Fed will raise rates, slow the economy back down, and turn the whole exercise into a wash. If fiscal stimulus only keeps inflation from falling too far below the Fed's target, the Fed won't bother to lower rates like it otherwise would have. In either case, the economy is no better off with fiscal stimulus than it would have been without. Or, as economists put it, the multiplier is zero -- for every dollar of stimulus spending, the economy is zero dollars larger.
Everything changes when rates fall to zero, even if it they shouldn't. Suppose a big shock hits the economy -- a shock so big that even zero interest rates can't turn things around. In other words, suppose it's 2008 all over again. In this case, fiscal stimulus won't just crowd out monetary stimulus, because the Fed can't cut rates anymore -- it can't cut below zero. Fiscal stimulus will make the economy better off, and perhaps substantially so.
There aren't many natural experiments when it comes to fiscal policy at the zero bound, but the ones we can observe suggest the multiplier is nonzero and big. Robert Gordon and Robert Krenn looked back at our "arsenal of democracy" days from 1939 to 1941, when we ramped up war production but before war-rationing, and found the multiplier peaked at 1.8, which is in line with the IMF's top-end estimate of 1.7. Remember, the multiplier tells us how much bigger the economy is for every dollar of stimulus, so a multiplier greater than one means the economy has grown by more than the size of the stimulus.
But this shouldn't be true! The Fed can do more than just cut interest rates. It can buy long-term bonds and make promises about future policy, too; the former is what we call quantitative easing, and the latter is forward guidance. In theory, it shouldn't matter if rates are at zero -- the Fed should still be able to stimulate the economy. And it can. It has. Just not as well as normal. For one, the Fed has been much slower to use these unconventional policies than it has been to cut interest rates; for another, it's unclear how much oomph these unconventional policies have -- Fed governor Jeremy Stein worries there are diminishing returns with quantitative easing. The calculus might well be different under a different monetary regime, like NGDP targeting, but you fight recessions with the Fed you have, and the Fed we have leaves room for fiscal policy to work.
Never more so than today. That's what Ben Bernanke has been telling Congress, albeit buried in the Fed's economic projections, which you can see below. Notice the Fed doesn't expect inflation to get above 2 percent at anytime in the next three years.
It might not look like it, but forecasting sub-2 percent inflation nowadays is the Fed's way of begging Congress to borrow more. That's the big implication of the Fed's big policy moves the past few months. The Fed is already buying $85 billion of bonds a month on an open-ended basis and has promised not to raise rates before unemployment falls below 6.5 percent or inflation rises above 2.5 percent. But it still thinks inflation will remain subdued, despite its bond-buying. In other words, the Fed is telling us it will tolerate a bit more inflation, but it won't create it. That's as good an invitation as Congress is going to get to cut taxes or increase spending, at least until inflation is around 2.5 percent. Now, the Fed might buy fewer bonds than it otherwise would if Congress does more, but we know it won't raise rates -- there's little guessing how much fiscal stimulus the Fed will allow. The multiplier is big now.
It's right out of Ben Bernanke's playbook. As Tim Duy, a professor at the University of Oregon, points out, Bernanke's often cited "helicopter drop" speech about how to stop deflation -- the idea was you could drop money from the sky as a last resort -- did not say a central bank could do this on its own. Bernanke said a "determined government" could "always generate higher spending and hence positive inflation," emphasis on the word government. Bernanke wants Congress to help him, and he's doing everything he can to let them know.
Although at this point, I doubt Bernanke is any different from the rest of us. He'd probably settle for a fiscal cliff deal that averts most of the austerity set to kick in, forget new stimulus.