The combination of eye-popping headline inflation of 5% year over year and dramatic expansions of the Federal Reserve’s lending activities to limit the credit crunch raise a key question: Are we asking too much of monetary policy? The simple answer is yes. The expansion of the Fed’s lending has been extraordinary in scale and scope. But it is not the best response to the present credit crunch, and may bring unwelcome side effects. To assess the Fed’s role as firefighter in the current financial turmoil, it is useful to start with the roots of the problem. Shocks to financial institutions’ net worth affected the supply of credit from those institutions. Such credit restrictions reduced consumption and investment — otherwise known as a “credit crunch.” The Fed’s interventions have, of course, aimed at liquidity — the ability to fund increases in assets and meet obligations as they become due.
Glenn continues with a very good discussion of risk management and the role of the Federal Reserve but then he returns to this inflation theme:
It is worrisome that the Fed’s own 2008 projections have risen over the year both for headline inflation (by about 1.5 percentage points) and core inflation (by about 0.2 percentage points). Furthermore, the Fed’s projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate. A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix. It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand. Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values — along with a cut in corporate tax rates to promote investment — would offer a much more potent tonic.
Mark Thoma weighs in by saying tax policy is not the only part of the fiscal policy tool kit:
I agree that Fed policy alone may not be enough to get the economy back on track, I’ve argued that for a long time. But tax cuts are not the only option for stimulating the economy, government spending can also be used, and in theory on short-run stabilization policy, a one dollar increase in government spending has a bigger impact on GDP than a one dollar tax cut. Infrastructure is an obvious target for spending, it’s surely needed, but there are other areas that could use help as well.
If Glenn and Mark are concerned about easier monetary policy increasing inflation – then how can they be supporting fiscal stimulus? In at least the closed economy version of the standard Keynesian model, the Phillips curve is the same for both forms of aggregate demand policies. OK, easier monetary policy may lead to more dollar devaluation than easier fiscal policy but given our current account deficit, wouldn’t increasing net exports be a good thing? I trust neither Glenn nor Mark are in the McCain-National Review camp of hoping a strong dollar will boost net exports!