Opinion

The limits of the Fed

How much can the Federal Reserve really boost the economy?

Mainstream economic policymaking rests on a division of labor: The Federal Reserve should worry about managing the macro-economy — balancing job creation against inflation — while Congress should focus on balancing its budgets. But now this way of doing business is coming under assault, thanks to things like Modern Monetary Theory and the left's push for Medicare-for-all and a Green New Deal.

But here's the funny thing: Even if you set aside this big clash of ideas and grant mainstream economics its assumptions, this assignment of roles makes no sense.

Recall that the central bank's main job is to adjust interest rates. Increasing interest rates cools off inflation but also squashes job and wage growth. Cutting interest rates boosts job and wage growth but also risks giving inflation more room to rise. Monetary policy is a permanent high-wire act, always trying to hit the right balance between these competing forces.

Now, when pressed, mainstream economists admit you could theoretically use fiscal policy to do the same thing. Congress could just set its taxing and spending programs to hit the sweet spot between maximum employment and price stability — and that can mean small or big deficits, depending.

Most of the economic profession just doesn't think that would be wise. It's a prudential and political objection, rather than an economic one.

From many economists' perspective, trusting a bunch of politicians to balance the competing forces of aggregate demand and inflation is crazy: They're bound to screw it up. Fed officials, by contrast, are highly educated experts protected from direct political pressures.

Furthermore, the mainstream believes interest rates are a much better tool for managing the economy; taxes and spending are too easily politicized.

Both of these assumptions are highly questionable, to put it mildly.

But for our purposes here, let's assume they're both correct. Does that lead to the conclusion that Congress should focus on "paying for" its spending over the long run?

Not at all.

Monetary policy is asymmetric. It's quite good at holding down economic growth and preventing inflation. But it's not nearly as good at boosting economic growth.

Part of the problem is the zero lower bound. Interest rates can rise as high as they want. But they can't fall below zero. (Well, technically they can. How well it works is another matter.) If interest rates hit the zero lower bound, but the economy still needs more stimulus, monetary policy is largely out of ammunition.

But there's an even deeper reason.

Contrary to popular belief, banks don't loan out the money they receive from reserves and deposits. When they loan, they're actually creating new money from thin air. Banks hold reserves because regulations require them to, and they hold deposits because doing so helps them turn a profit. But the money banks loan doesn't "come out of" either bucket.

Ultimately, the profit motive is what prevents banks from just creating endless credit willy-nilly: If banks create too much credit, interest rates fall too far and banks stop turning a profit. If they create too little credit, interest rates rise too high and drive off customers — and the banks stop turning a profit.

How much credit is too much or too little depends on wider conditions. An economy that's really booming will justify much higher interest rates than an economy that's in the doldrums.

Now, back to the Federal Reserve: Crudely put, the Fed adjusts interest rates by forcing banks to charge higher interest rates than they might otherwise want to. Again, the profit motive is crucial here: It simply doesn't make sense for banks to charge anyone less than they charge each other, or than the interest they get from the Fed itself. And the Fed can adjust both dials. But the central bank has no equivalent ability to force banks to charge lower interest rates than they might otherwise want to. If wider economic conditions justify lower rates, the best the Fed can do is get out of everyone's way, and hope they go low enough.

In short, the Fed can push down on the economy. But it can't really push up on it.

For decades, we assumed the economy would supply that upward pressure naturally. To their chagrin, economists are discovering this isn't true: Interest rates and inflation have both been steadily falling for almost four decades and are now near rock bottom despite our super-low unemployment. Wages have stagnated and inequality has skyrocketed. According to the Fed's own research, the gap between actual economic output and potential output — the threshold beyond which more stimulus just results in inflation — could still be as high as 12 percentage points. That's an enormous hole, 10 years on from the Great Recession.

If the upward pressure can't come from the Fed, and it isn't coming from the economy, there's only one other option: fiscal policy.

Practically speaking, it's hard to say how this would work, since our entire economic policymaking apparatus is built around the assumption that deficits are bad. But like I said, the Fed has tools to estimate how far we are below potential. And politicians have sophisticated outfits like the Congressional Budget Office to model the economic effects of bills. Relying on those resources, one thing Congress could do is design its annual budgets to always stimulate the economy by two or three percentage points beyond maximum potential output. Then the Fed could come in and press down just enough to balance us out at maximum output.

The advantage of this approach is Congress would still be following a very dumb and simple rule: always try to overheat the economy a bit. The actual balancing would still be Fed officials' job, and they'd still use interest rates to make the fine-tune adjustments.

But the Fed would also have the one key thing it currently lacks: Something to push against.

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