Where the Fed Goes From Here

The view from Jackson Hole.

Photographer: David Paul Morris/Bloomberg

Investors scouring Janet Yellen’s speech last Friday for clues on short-term interest rates came away disappointed. The Fed chair chose to deliver a more important message: The future of U.S. macroeconomic policy cannot be like the past.

Dealing briskly with the immediate future, Yellen made it clear that the Fed’s short-term stance is watchful waiting -- just like before the speech. Turning to the main theme of the annual economic policy conference, Yellen addressed a much bigger question.

Mainstream economics has long proposed a basic division of labor between monetary policy and fiscal policy. Interest rates are easy to change, so they’re well-suited to managing the short-term economic cycle; taxes and public spending involve hard choices and far-reaching consequences, so they aren’t. Yellen’s basic point was that this thinking will have to change.

QuickTake Secular Stagnation

Demographic pressures and slower productivity growth are pressing down on future interest rates. This is a structural, not cyclical, phenomenon. As a result, forecasters expect the federal funds rate to average about 3 percent in the long term, compared with an average of more than 7 percent between 1965 and 2000. This means that, in future downturns, the Fed won’t be able to cut interest rates by as much.

Now, this reduction in the potency of monetary policy isn’t quite as bad as it looks, Yellen argued. That 3 percent rate is a long-term average -- the starting point for interest-rate cuts will often be higher. And the Fed has new instruments for monetary control -- quantitative easing, paying interest rates on excess reserves, and so-called forward guidance. In extremis, as in Japan and Europe, interest rates can be pushed below zero. 

In each case, however, serious difficulties arise. Where they’ve been tried, negative interest rates haven’t been a conspicuous success. Forward guidance is especially hard to get right in the U.S., because the Fed’s policy makers rarely agree with each other and enjoy advertising the fact. And the idea that QE, with its attendant asset-price inflation and risk of unintended consequences, should become a standard tool of monetary policy is anything but reassuring.

QuickTake Negative Interest Rates

Then what’s the alternative? The answer must be fiscal policy. In severe slumps, like the one that followed the crash of 2008, governments do resort to fiscal stimulus as an emergency measure. The challenge, though, is to make fiscal policy a more usable instrument of macroeconomic management in less extreme circumstances, so that it can carry more of the burden traditionally assigned to monetary policy.

That certainly isn’t going to be easy. Possibilities include reforming the tax system in ways that make revenues more sensitive to the economy’s position in the cycle -- nudging the tax base from income to consumption would serve that purpose, for instance. The same goes for higher spending on unemployment benefits and other programs that respond automatically in a slowdown. Arrangements in Congress for expediting temporary action on a limited number of tax and spending initiatives -- separating cyclical fiscal policy from the larger (paralyzing) debate about the size of the state -- would be valuable as well.

Merely to suggest such ideas is to see how hard this will be. Only remember: If strengthening fiscal policy for countercyclical purposes proves impossible, QE and other risky measures will, out of necessity, become orthodox. That’s an outcome well worth resisting, and a theme Yellen should keep coming back to.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.