Commentary: Should the Fed Raise Rates? Wrong Question!
The big question these days is when the US Federal Reserve will finally raise its target interest rate for the first time in almost a decade. Its monetary policy committee is meeting this week to decide whether to do just that.
Unfortunately, this is the wrong question. Whether the Fed moves this week or next month will make little difference over time. If it takes too small a step now – or none at all – it can take a bigger step later.
The right one is when will the federal government do more to improve our economic performance and no longer leave the Fed to battle alone.
A disappointing recovery
Since the Great Recession ended in 2009, the pace of our recovery has been disappointingly slow and much worse than previous ones.
This is hardly surprising. The results of work done with one hand tied behind your back will be disappointing no matter how hard you try. And that is precisely what the US has been doing since 2011.
In other words, fiscal policy – in the form of federal government spending and taxation – has been lacking and has even acted as a headwind working against the recovery, forestalling its momentum. Instead, the recovery is almost exclusively the result of the Fed’s unprecedented monetary policy.
There is no logical reason for this. More than 100 years ago, the US laid the foundation for two tools to help it resist unwanted changes in the economy, in employment levels and in inflation. The Fed was one. It’s time our fiscal policymakers relearned how to use the other.
Two powerful new weapons
In 1913, the US Constitution was amended for the 16th time to include a provision that permitted a national income tax be used to raise revenue for the federal government. That allowed the US to collect more money than it had previously, when tariffs were Washington’s primary source of revenue.
In the same year, by a fortuitous coincidence, Congress passed the first version of the Federal Reserve Act, which laid the foundation for a national monetary policy by creating a central bank. The act was later amended to specify the Fed’s two primary mandates: maximum employment and stable prices.
At the time, use of these tools – fiscal policy and monetary policy – was not understood or hotly debated (and I’m not sure we understand them fully even now). But, during the Great Depression with economist John Maynard Keynes as our top teacher, we learned that government spending in excess of revenues can stimulate economic growth (and possibly cause inflation), while spending less can stifle it or even cause output to contract.
We later learned through theory and experience that efforts to reduce fiscal deficits when an economy is weak can actually enlarge them because declining activity reduces tax revenue. And conversely, efforts to reduce surpluses (by spending more) when the economy is strong can enlarge them even further because inflation leads to higher revenues.
As for monetary policy, we came to realize that it can also be used to stimulate or hold back nominal growth, primarily by cutting or raising short-term interest rates. But monetary policy works mainly on the financial sector and has not been geared toward affecting specific areas of the economy.
Two are better than one
One clear area of agreement, however, is that using both fiscal and monetary policy together is better than relying on only one of them to stimulate growth when the economy is running below its potential, as it seems to be now. And a major reason the recovery has been so sluggish, in my opinion, was the lack of sustained fiscal stimulus.
There are two ways to evaluate the effectiveness of fiscal policy: how it’s structured and how well it counters cyclical variations in economic activity.
The first test refers to whether the US is spending too little relative to revenue, creating chronic surpluses and failing to use its potential domestic output, or spending beyond its means and creating persistent deficits.
The second involves how well government is acting to counter or reduce the ups and downs in economic activity that occur from time to time. This means stimulating growth during slowdowns in an effort to keep our economic engine from stalling and retarding it during expansions to keep it from running too hot.
Over time, deficits and surpluses should roughly average out as spending relative to revenue goes up in times of economic weakness and down when growth is strong.
We have failed both tests.
Congress has generated chronic deficits almost continually since 1970 because its members have refused to raise sufficient revenue through taxes or other means to match long-term spending commitments already agreed to.
And it has also failed to use fiscal policy sufficiently to counter short-run declines in economic activity, through added spending or tax reductions, for example, even citing the persistent structural deficit as an excuse. Congress adopted the so-called budgetary sequester in 2011 – across-the-board spending cuts to reduce the deficit if another plan was not agreed to. It took effect in 2013, thus positioning our fiscal policy to slow economic growth at a time when stimulus was still needed.
The Fiscal Impact Measure, developed by the Brookings Institution’s Hutchins Center, shows that the net fiscal impact of federal and state spending and taxation has been about zero or negative since 2011, meaning it curbed economic growth rather than stimulated it. The center estimates it has reduced real GDP growth by about one-third of a percent each year. That’s not insignificant, with GDP growth averaging a little below 2 percent from 2011 to 2014.
Monetary policy can’t do it alone
While the US government began to rein in its stimulus spending in 2011, the Fed stepped up its efforts because it correctly read the economic trends and saw that the recovery was flagging.