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Pull Back the Curtain

To understand fiscal and monetary policy.

12:00 AM, Mar 30, 2013 • By IRWIN M. STELZER
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All of this is playing out against some little-noted progress on the fiscal front. The president’s rout of House Republicans in the battle of the fiscal cliff produced an increase in taxes on “the wealthy” that will bring an additional $700 billion into the Treasury over the next decade. If the caps imposed on spending by the sequester hold, spending will come down by about $1 trillion compared with the levels that would otherwise have prevailed. These cuts—in Washington that means lesser increases in planned spending—are on top of $1.5 trillion in spending reductions agreed by the president and the Congress in 2011. Throw in the lower borrowing costs associated with these lower deficits and you have reductions of almost the $4 trillion that will eventually lower the deficit to about 3 percent of GDP, a level most economists consider sustainable. The Congressional Budget Office estimates that this year’s deficit will come to $845 billion, or 5.3 percent of GDP, half the level in 2009. True, the cuts and tax increases are not falling where they might best contribute to growth, but they are bringing the deficit down, at least until the cost of Obamacare and the demands of the baby boomers hit the budget some years hence. So fiscal policy is less of a train wreck than it was only months ago. If they were of a mind to chortle, Republicans might point out that the current course, if maintained, would result in $4 of spending cuts for every $1 of tax increases, far superior from their point of view to the ratio suggested in the much-hailed Simpson-Bowles proposal.

Which brings us to monetary policy, and Federal Reserve Board chairman Ben Bernanke’s insistence on printing money—$85 billion a month—so long as the unemployment rate remains stuck above something like 6.5 percent. Or until he is convinced that the fiscal tightening described above will not do to the U.S. economy what austerity has wreaked on the Greek, Spanish, Portuguese, and (some say) British economies.

We are now in the third round of such “quantitative easing,” or QE3, which is keeping interest rates down and home-buying and share prices up. Bernanke takes credit for preventing the economy from sinking back into recession, not without some justification. Were he less modest, he also might claim to be the role model for Mark Carney, the new governor of the Bank of England, and Haruhiko Kuroda, the new head of Japan’s central bank—among others. All are captains of their nations’ QEs, battling recessionary headwinds and heading, they hope, for the calm waters of sustainable non-inflationary growth.

Until now, little attention has been paid to just how the Fed might bring this era of easy money to an end. Now, the Fed has changed its policy from we “will” continue buying $85 billion per month to we “decided to” do so, subtly suggesting that at some point it will decide not to. Bernanke has already said that the “rate of flow of purchases … [will] respond … to changes in the outlook.” And William Dudley, president of the Federal Reserve Bank of New York wants to “calibrate” the speed of the Fed’s printing presses “to material changes in the labor market outlook, ... sufficient evidence of economic momentum.”

Small problem: the Fed has consistently overestimated future growth by a non-trivial 1.4-1.9 percentage points, according to former White House chief economist Larry Lindsey. So if the Fed does regulate the volume of purchases to its “outlook,” it is more likely to cut too much too soon rather than too little, too late. Which would be bad news for those who are enthusiastically stocking up on shares, and good news for those who believe the Fed is stoking future inflation by not phasing out its purchase program right now.

But don’t start dumping shares or looking for that new house. One doesn’t have to read between the lines of Bernanke’s speeches to know that he will take considerable persuading before starting to cut purchases of bonds and mortgages. He believes he has what he perceives is the obligation of a central banker to lower the unemployment rate—next week’s jobs report bears watching—and wants hard evidence that Obama’s tax increases and Congress’s spending cuts won’t derail the not-yet-robust recovery, which produced an annual growth rate of a mere 0.4 percent in the final quarter of last year. Until then, the presses will roll, and interest rates will cause continued gnashing of teeth by frugal savers in search of yield.

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