Two big economic issues are dominating Washington, D.C., at the moment: negotiations in Congress over the federal budget and deliberations at the Federal Reserve about when to rein in the Fed’s extraordinary easy-money policy. The two are more closely related than most people may realize.
Many members of Congress have criticized the Fed for leaving the monetary stimulus plan known as quantitative easing in place for too long, claiming it distorts the normal functioning of markets and could ultimately cause inflation. Yet one big reason QE remains in place is that Congress is doing its own job so poorly. The Fed’s aggressive policies may even enable Congressional dysfunction and harmful political antics such as the October government shutdown and ongoing brinkmanship over whether to honor the government’s debt.
By some accounts, the Fed was prepared to begin curtailing QE in September but didn’t because of concerns about the budget standoff looming a few weeks later. By October, economists began to predict that the effects of the shutdown would delay a QE pullback until March of 2014 or even later. “Federal fiscal policy continues to be an important restraint on growth,” Fed chairman Ben Bernanke said at the time. “Upcoming fiscal debates may involve additional risks to financial markets and to the broader economy.”
The same thing is probably true now. Voters trashed Congress for the October shutdown and the drama over raising the nation’s borrowing limit, which cost the economy more than $20 billion by some estimates. That suggests Congress wouldn’t be foolish enough to threaten the same things again. Yet as Democrats and Republicans enter the home stretch of negotiations to come up with some sort of tax-and-spending compromise by a January 15 deadline, there’s no obvious reason why the two sides would suddenly cooperate. There are a few cheery reports predicting some kind of budget deal before Christmas, but those recall many other moments of dashed optimism. If anything, a lower budget deficit for the current fiscal year could allow both sides more room to dig in their heels on their pet issues.
Fed stays loose, Congress dithers
The real timing of the Fed's first QE pullback remains the biggest guessing game on Wall Street. Richmond Fed President Jeffrey Lacker, a non-voting member of the Fed's policy-setting committee, said recently that the Fed would probably discuss a pullback at its upcoming mid-December meeting. Still, making a change now might complicate the typical year-end adjustments investors make and rattle markets more than necessary. The longer the Fed waits to tighten its policy, however, the longer Congress can get away with dithering, since the Fed will be there as usual to help offset any further damage Congress may do to the economy.
Some economists feel the situation ought to be reversed — with Congress doing the work to stimulate the economy through spending and longer-term debt reduction, and the Fed backing away from its extraordinary intervention in the markets. Harvard economist Martin Feldstein recently called for a five-year plan to spend $1 trillion or more on infrastructure, new military gear and other things in order to boost growth and allow the Fed to back off. That would be more stimulus spending than even President Obama has called for. And Feldstein, unlike Obama’s allies, is a conservative stalwart who was Ronald Reagan’s top economic adviser in the 1980s.
In Japan, Bernanke’s counterpart, Haruhiko Kuroda, has spearheaded an aggressive, Fed-style stimulus plan at the Bank of Japan, while also being a vocal advocate of other measures beyond his turf, such as raising taxes to help reduce government debt and reforming outdated labor laws. Bernanke has been much more circumspect about telling U.S. legislators what he thinks they ought to do, speaking, when he does, in the inscrutable professorial language that has become a hallmark of his position.
“It would be better to have a mix of tools at work — not just monetary policy, but fiscal policy and other policies as well,” Bernanke said in September, by way of urging Congress to do something — anything — to help the economy. That remark, needless to say, didn’t make headlines.
Frustration with Congress is so deep that Bernanke’s popularity might soar if he were to take on Congress more deliberately. “It would have been nice if the Fed had been tougher on Congress to get its act together,” says Peter Fisher of BlackRock. But the Fed probably can’t go as far as pulling back on monetary policy as a way to compel Congress to do more on fiscal policy. “The Fed is always stuck taking the thrust of fiscal policy as a given, then adjusting at the margin around the thrust of fiscal policy,” says Fisher.
The coming year, however, could test whether a pullback in the Fed’s monetary stimulus raises pressure on Congress to help the economy. By the end of 2014, most forecasters believe, the Fed, under incoming chair Janet Yellen, will be well on its way toward ending QE, though it still plans to keep short-term interest rates extremely low until 2015 at least. A modestly growing economy might let Congress off the hook for the type of stimulus plan Feldstein is calling for.
But if there’s trouble, Congress may have to reverse the spending cuts that have gone into effect over the past year, and shelve any efforts to reform entitlement programs that emerge from the current budget talks. Markets could also sink if the Fed reverses course and investors lose their nerve, leaving Congress--rather than the Fed--in the uncomfortable position of trying to reassure markets. We’ve gotten so used to Congressional inaction that the idea of Congress helping the economy is almost a contradiction in terms.
Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman .
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