Lessons from Monetary Policy for Fiscal Policy

On Friday, Fed Chairman Bernanke provided a lesson that fiscal policymakers should take to heart: Expectations matter.

In a much anticipated speech at the Federal Reserve Bank of Boston, Bernanke confirmed that the Federal Open Market Committee (FOMC), the Fed's decision making board, is likely to move toward generating more liquidity and adding more downward pressure on interest rates. Fed-watchers were anxious to learn whether Chairman Bernanke would support additional easing (now commonly referred to quantitative easing, round two--or just QE2 for short). That question seems to have been answered with a resounding "yes." With inflation trending too low and unemployment too high, Bernanke said taking further monetary policy steps are warranted.

But then he went on to note:

"To address such concerns and to ensure that it can withdraw monetary accommodation smoothly at the appropriate time, the Federal Reserve has developed an array of new tools. With these tools in hand, I am confident that the FOMC will be able to tighten monetary conditions when warranted, even if the balance sheet remains considerably larger than normal at that time."

Call this the Announcement Effect Club: Monetary Policy version.

Just as a lack of an "exit" from expansionary fiscal policy can lead to big trouble when the economy recovers, the perception that the Fed is a helicopter that perpetually drops money also can cause trouble. Perceptions of both fiscal and monetary policy can be affected by actions that, on their own would seem to be small, but, in fact, “anchor” basic views of where we’re headed in the future. So the Fed has talked about keeping rates low "for an extended period," meaning "we will not raise interest rates for awhile." At the same time,  Bernanke has talked about ways to tighten monetary policy effectively when we reach that point, in an effort to show that the Fed's expanded balance sheet will not be permanent.

This strategy in monetary policy is easily adaptable in fiscal policy. Budget blueprints such as the President's Budget and the Congressional budget resolution (or the lack thereof this year!) show when, how, and to what extent fiscal policy may be expanded or tightened in the future. Legislative actions, such as how Congress deals with the President's Fiscal Commission's recommendations or how the House and Senate handle a possible ad-hoc Social Security payment, can idicate how serious policymakers are about getting the nation's fiscal policy back on a sustainable track.

Expectations matter – and expectations of policy can be extended into the future, as far as the eye can see, whether we’re talking monetary policy – or fiscal policy.

The fiscal world can learn plenty from the Fed here. Fiscal policymakers have been unable to constructively shape expectations that policy will be well- managed. Of course, the number one indication of seriousness would be to enact a medium-term deficit reduction plan that kicks in slowly once the recovery is on firm footing.

To take some lessons from the Fed, just try substituting “fiscal” for “monetary” – and the appropriate fiscal concepts and institutions where applicable – in Bernanke’s remarks:

“To evaluate policy alternatives and explain policy choices to the public, it is essential not only to forecast the economy, but to compare that forecast to the objectives of policy. Clear communication about the longer-run objectives of monetary policy is beneficial at all times but is particularly important in a time of low inflation and uncertain economic prospects such as the present. Improving the public's understanding of the central bank's policy strategy reduces economic and financial uncertainty and helps households and firms make more-informed decisions. Moreover, clarity about goals and strategies can help anchor the public's longer-term inflation expectations more firmly and thereby bolsters the central bank's ability to respond forcefully to adverse shocks.”