People like to talk about and get jazzed over policy “coordination”, which these days means co-operation between the monetary and fiscal authorities.
In this report, I pull together some themes I have been pushing over the years to set out what form the monetary-fiscal coordination is likely to take – or, really, continue taking. These are not new ideas, and my objective here is more to connect some dots ahead of the election than to prove any one particular dot.
There are three points in particular to emphasize here. First, many analysts severely jumped the gun by anticipating that policy coordination in its most potent form could quickly put an end to lowflation. It seems to me that they missed an entire cycle in which the Fed was effectively forced to err on the side of ease. It is amazing they would declare victory here. It has taken time for policy makers to internalize the secular stagnation environment and to grope toward a policy response that is plausible and likely to be effective. However, the required learning has probably been achieved, with the passage of time. So we should now get aboard the fiscal contribution to reflation over the coming years — as opposed to from here to Election Day.
Second, this process is likely to involve a lot less drama than some of the popular stories imply. The image of a Fed Chair and Treasury Secretary appearing jointly before the cameras to announce some novel program is hardly implausible. The Blackrock Institute set out a workable version of that a couple years ago. And while their distillation was a very helpful advance, they relied on ideas that had been in the air a while. But the much more likely scenario is that the coordination is mostly achieved by both the Fed and Treasury reacting, i.e. endogenously, to the same real-economy forces, associated with secular stagnation. That is r*, has fallen, outright and relative to g*. The lower r* exacerbates the constraints implied by the effective lower bound on rates, encourages a sense of urgency at the Fed about inflation expectations, and encourages an enduring shift to larger fiscal deficits, which quite obviously is already in train. This is not something that needs to be announced.
Third, and very closely related to the second issue, the decline of r* does not necessarily make it all that more difficult for policy makers collectively to achieve the objectives that the Fed has recently formalized more explicitly. It – arguably at least – just affects the policy mix that is required to get us there. This is all mostly endogenous to the developments in the real economy, although inevitably with recognition lags that have frustrated the eager beavers over the past decade. The Great Man take on events does not apply here. But we all learn, along with the markets. Just because your favorite overconfident policy entrepreneur got it badly wrong does not disqualify evolution.
The evolution will probably extend most quickly if Fed Governor Lael Brainard ends up at Treasury. She will explain the complicated bits to the Biden Administration and possibly Democratic Senate. But even in other scenarios we probably get there, just more slowly.