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April 21, 2005
Landings, Hard and Soft: Part 3
Finally, we come to Brad Setser's take. Actually, Brad and I have shared thoughts on this for a while now, and I have no quarrel with his opinion that the current situation is unsustainable. So rather than repeat myself, I'll relay these thoughts from a speech given this morning by Sandra Pianalto, president of the Cleveland Fed.
First, on the issue of fiscal deficits, yes, we take them seriously.
Let me turn now to the issue of whether large budget deficits may undermine central banks' success in maintaining low and stable inflation rates...
The current level of budget deficits certainly understates the magnitude of fiscal pressures. Both the United States and Europe face demographic changes where we see entitlement liabilities growing faster than the tax base available to support them. While these issues are not new, they are serious and should be addressed sooner rather than later...
However, there is no need for deficits to be inflationary. The prospect of inflation arises only if the central bank ignores or, even worse, tries to resist any rise in real interest rates. By doing so, the central bank would keep its policy rates too low and inadvertently ease monetary policy. Of course, the real risk of an excessively stimulative monetary policy is that inflation expectations may eventually become unanchored. History shows that once inflation expectations become unstable, more stringent policy actions might be required.
A central-bank commitment to price stability can avoid that outcome. A central bank cannot always offset the effects of government deficits on economic growth and stability. But the more credible the central bank's commitment to price stability, the less likely it is that an inflation premium will be built into market interest rates, and the less likely it is that rising inflation expectations will distort economic decisions.
And about those external balances?
Now I would like to discuss how monetary policy can best contribute to resolving the challenges brought by external account imbalances. Substantial current account deficits developed in the 1980s, and these deficits now stand at record postwar levels as a share of GDP. I think everyone agrees that these levels are unsustainable, and that a reversal is inevitable, even if the timing and pace of the adjustment are uncertain.
Some people envision a soft landing. As we all know, a return to current account balance will ultimately require that U.S. households consume less and save more of their incomes. Households could become concerned about having enough money for future consumption and step up their saving, even at today's interest rates. The more commonly expected scenario, though, is that foreign savings coming into the United States could become less plentiful over time, driving up interest rates. Then, households might be induced to save more and spend less.
If a substantial turnaround in U.S. current account deficits results in higher equilibrium real interest rates, the FOMC would most likely need to adjust its federal funds rate target accordingly to prevent a change in its policy stance. It is also possible that a decline in the exchange value of the dollar could result in temporary upward pressure on the price level, due to rising import prices and the prices of import-competing goods. The first responsibility of the central bank is to ensure that these price pressures do not feed into higher inflation expectations in the long run. Once again, a clear commitment to price stability - in words and deeds - is the best contribution the central bank can make to the adjustment process toward more sustainable external account positions.
The soft-landing point of view is really just the expectation that the process of adjustment will be a smooth one. I believe that a gradual and orderly transition toward smaller current account deficits is the probable outcome.
What should the central bank be doing today? Glad you asked.
How, then, should monetary policy deal with current account imbalances today? I do not think that the FOMC should take preemptive measures to address these imbalances. However, I do think that the Committee should continue to bring the federal funds rate target to a level that is consistent with maintaining price stability in the long run. If we achieve that, then we will be in a position of strength to address whatever challenges arise.
Would you be surprised to hear that I completely agree?
UPDATE: Brad DeLong, Mark Thoma, the Prudent Investor, and William Polley take note (here, here, here, and here) of Chairman Greenspan's dissastisfaction with the current fiscal outlook, and his call to bring back the Budget Enforcement Act.
UPDATE 2: Concerning the Chairman's testimony, Max is not impressed.
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Policy thought for the day
William J. Polley
Given all the talk about soft landings as well as Greenspan's dire warning on the deficit today, I thought this would be a good way to sum up my thoughts at the moment. Thanks to David Altig for the link.... [Read More]
Tracked on Apr 21, 2005 4:52:22 PM
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