The Congressional Budget Office’s latest report on the budget outlook revealed (perhaps unintentionally) that fixating on Congress and the President as the central players in the federal deficit drama is a mistake. According to the CBO, the path the federal budget deficit will follow over the next 10 years is just as much (if not more so) a question of Federal Reserve policy.Multiplier Effect
It’s Time to Shift the Focus of the Deficit Debate
Michael Stephens
It's the interest rate, stupid. And that depends on the Fed's inflation target, since the interest rate is a policy variable.
Interest rates are a policy variable. This growth in debt-service costs, in other words, represents a choice. The question of whether or not it’s the right choice should receive a lot more attention in our popular discussions, alongside the obsession with “grand bargains” and the rest. We’re often told (in a near inversion of the truth) that rising budget deficits are the biggest near-term threat to the US economy. But if you look at what the CBO’s projection says about our collective priorities, what we see here is a decision to allow interest rates to rise at the expense of the deficit....
However, given some model of the interactions between unemployment, inflation, interest rates, and budget deficits, the question of what particular tradeoffs we are making, or should make, needs to be brought to the fore. One issue raised by the CBO’s projection is the Fed’s apparent commitment to place a 2 percent ceiling on inflation. Is maintaining this ceiling worth it, given the price that needs to be paid in terms of a more elevated unemployment rate and increased political pressure to reduce spending on essential government functions? How harmful would inflation in the 3–4 percent range be, given the costs of trying to avoid it? Whatever your answers are, these questions need to become a more routine part of the deficit debate, for the sake of better public understanding of the choices being made on our behalf.
4 comments:
The Fed controls the interest rate, not the inflation rate. There are many factors in inflation beyond the Fed's control, including wages, global prices and competitive conditions. And of course the effect of interest rates on inflation is ambiguous. This seems like an extremely poor confused analysis to me...
Detroit Dan, the Fed conducts monetary policy by setting the interest rate, based on the assumption that the interest rate and inflation rate are inversely correlated. So raising the interest rate will lower the inflation rate as rates rise in response along the curve since other rates are based on the fed funds rate. This applies vice versa except at the lower bound. That's the theory underlying monetary policy conducted by interest rate setting.
The interest rate is policy variable that is set by the Fed wrt its expectations about future changes in the price level, which is the inflation rate. The Fed has an inflation target and it sets the interest rate based on expectations of the change in the inflation rate.
If the Fed expects the price level to rise faster than its target rate of inflation (~2%) it will raise the interest rate to head off the increase. I does this by increasing the cost of money including what the government pays to borrow along the yield curve. That increases the amount that the government pays in interest and that adds to the deficit.
MMT points out this cuts both ways. While increasing the cost of borrowing, it also increased the amount of interest paid, which increases $NFA, which is inflationary near full employment.
Tom, is there any actual empirical basis for that assumption - the inverse correlation between the inflation rate and the interest rate - or is it just more monetarist bollocks? How tight is the connection. Right now the the interest rate is as low as it can go and inflation is still very low. The neoclassicals are all running back to their "natural rate" models and saying this just shows that the current natural rate is below zero. But maybe there is no natural rate. And maybe the whole idea that the Fed can target a rate of inflation is a myth.
There is some correlation, but not enough to prove the assumption link. Moreover, the causality is disputed. The transmission mechanism is not there, as Post Keynesians point out.
I'd say bullocks.
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