Investors scouring Janet Yellen’s speech Aug. 26 for clues on short-term interest rates came away disappointed. The Fed chair chose to deliver a more important message: The future of U.S. macroeconomic policy cannot be like the past.
Mainstream economics has long proposed a basic division of labor between monetary policy and fiscal policy. Interest rates are easy to change, so they’re well-suited to managing the short-term economic cycle; taxes and public spending involve hard choices and far-reaching consequences, so they aren’t. Yellen’s basic point was that this thinking will have to change.
Demographic pressures and slower productivity growth are pressing down on future interest rates. This is a structural, not cyclical, phenomenon. As a result, forecasters expect the federal funds rate to average about 3 percent in the long term, compared with an average of more than 7 percent between 1965 and 2000. This means that, in future downturns, the Fed won’t be able to cut interest rates by as much.
Now, this reduction in the potency of monetary policy isn’t quite as bad as it looks, Yellen argued. That 3 percent rate is a long-term average – the starting point for interest-rate cuts will often be higher. And the Fed has new instruments for monetary control – quantitative easing, paying interest rates on excess reserves and so-called forward guidance. In extremis, as in Japan and Europe, interest rates can be pushed below zero.
But the idea that QE, with its attendant asset-price inflation and risk of unintended consequences, should become a standard tool of monetary policy is anything but reassuring.
Then what’s the alternative? The answer must be fiscal policy. Possibilities include reforming the tax system in ways that make revenue more sensitive to the economy’s position in the cycle – nudging the tax base from income to consumption would serve that purpose, for instance.
Merely to suggest such ideas is to see how hard this will be. Only remember: If strengthening fiscal policy for countercyclical purposes proves impossible, QE and other risky measures will, out of necessity, become orthodox. That’s an outcome well-worth resisting, and a theme Yellen should keep coming back to. •
Bloomberg View editorial.
