Princeton Economists Say Debt Can Impair Monetary Policy Rule

Excessive federal debt can weaken guidelines for the conduct of monetary policy, Princeton University economists said in a paper released today at a symposium held by the Federal Reserve Bank of Kansas City.

“Unsustainable fiscal debt levels can also undermine the credibility of monetary policy rules,” Markus K. Brunnermeier and Yuliy Sannikov said at Jackson Hole, Wyoming. “The central bank is forced to choose between inflation and government default” and can lose credibility or confront financial instability, they said.

Some Fed presidents, including Charles Plosser of Philadelphia, have proposed the central bank consider a clearer guideline in setting policy to achieve price stability and maximum employment. Fed officials discussed the use of a monetary policy rule at their July 31-Aug. 1 meeting.

Policy makers have said they won’t monetize the growing federal debt and have urged Congress to restore fiscal balance. The U.S. deficit will reach $1.1 trillion in 2012, according to the nonpartisan Congressional Budget Office. U.S. debt will total 73 percent of the nation’s gross domestic product this year, the highest level since 1950, the CBO said.

The Princeton professors’ paper, “Redistributive Monetary Policy,” said periods of deflation can influence the distribution of wealth in a society and monetary policy can work to stabilize an economy and stimulate growth.

Recessions such as the U.S. downturn from December 2007 to June 2009, which follow a financial crisis and are in part prompted by a buildup of debt, can lead to persistent weakness, they said.

“Recovery from financial recessions can be sluggish and protracted,” Brunnermeier and Sannikov said. In the U.S., “households are scaling back consumption to accumulate savings. In addition, the financial sector is slowly recapitalizing itself.”

The authors disagreed with the view that financial excesses should be addressed only through regulation, saying that stability and monetary policy are “interlinked.”

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net;

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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