Daily Bulletin

Business Mentor

.

  • Written by Daily Bulletin
imageFed Chair Janet Yellen's rates balancing act would be easier if the government got in the game.Reuters

The big question these days is when the Federal Reserve will finally raise its target interest rate for the first time in almost a decade. Its monetary policy committee is meeting this week to decide whether to do just that.

Unfortunately, this is the wrong question. Whether the Fed moves this week or next month will make little difference over time. If it takes too small a step now – or none at all – it can take a bigger step later.

The right one is when will the federal government do more to improve our economic performance and no longer leave the Fed to battle alone.

A disappointing recovery

Since the Great Recession ended in 2009, the pace of our recovery has been disappointingly slow and much worse than previous ones.

This is hardly surprising. The results of work done with one hand tied behind your back will be disappointing no matter how hard you try. And that is precisely what the US has been doing since 2011.

In other words, fiscal policy – in the form of federal government spending and taxation – has been lacking and has even acted as a headwind working against the recovery, forestalling its momentum. Instead, the recovery is almost exclusively the result of the Fed’s unprecedented monetary policy.

There is no logical reason for this. More than 100 years ago, the US laid the foundation for two tools to help it resist unwanted changes in the economy, in employment levels and in inflation. The Fed was one. It’s time our fiscal policymakers relearned how to use the other.

Two powerful new weapons

In 1913, the US Constitution was amended for the 16th time to include a provision that permitted a national income tax be used to raise revenue for the federal government. That allowed the US to collect more money than it had previously, when tariffs were Washington’s primary source of revenue.

In the same year, by a fortuitous coincidence, Congress passed the first version of the Federal Reserve Act, which laid the foundation for a national monetary policy by creating a central bank. The act was later amended to specify the Fed’s two primary mandates: maximum employment and stable prices.

At the time, use of these tools – fiscal policy and monetary policy – was not understood or hotly debated (and I’m not sure we understand them fully even now). But, during the Great Depression with economist John Maynard Keynes as our top teacher, we learned that government spending in excess of revenues can stimulate economic growth (and possibly cause inflation), while spending less can stifle it or even cause output to contract.

We later learned through theory and experience that efforts to reduce fiscal deficits when an economy is weak can actually enlarge them because declining activity reduces tax revenue. And conversely, efforts to reduce surpluses (by spending more) when the economy is strong can enlarge them even further because inflation leads to higher revenues.

As for monetary policy, we came to realize that it can also be used to stimulate or hold back nominal growth, primarily by cutting or raising short-term interest rates. But monetary policy works mainly on the financial sector and has not been geared toward affecting specific areas of the economy.

Two are better than one

One clear area of agreement, however, is that using both fiscal and monetary policy together is better than relying on only one of them to stimulate growth when the economy is running below its potential, as it seems to be now. And a major reason the recovery has been so sluggish, in my opinion, was the lack of sustained fiscal stimulus.

There are two ways to evaluate the effectiveness of fiscal policy: how it’s structured and how well it counters cyclical variations in economic activity.

The first test refers to whether the US is spending too little relative to revenue, creating chronic surpluses and failing to use its potential domestic output, or spending beyond its means and creating persistent deficits.

The second involves how well government is acting to counter or reduce the ups and downs in economic activity that occur from time to time. This means stimulating growth during slowdowns in an effort to keep our economic engine from stalling and retarding it during expansions to keep it from running too hot.

Over time, deficits and surpluses should roughly average out as spending relative to revenue goes up in times of economic weakness and down when growth is strong.

We have failed both tests.

Congress has generated chronic deficits almost continually since 1970 because its members have refused to raise sufficient revenue through taxes or other means to match long-term spending commitments already agreed to.

And it has also failed to use fiscal policy sufficiently to counter short-run declines in economic activity, through added spending or tax reductions, for example, even citing the persistent structural deficit as an excuse. Congress adopted the so-called budgetary sequester in 2011 – across-the-board spending cuts to reduce the deficit if another plan was not agreed to. It took effect in 2013, thus positioning our fiscal policy to slow economic growth at a time when stimulus was still needed.

The Fiscal Impact Measure, developed by the Brookings Institution’s Hutchins Center, shows that the net fiscal impact of federal and state spending and taxation has been about zero or negative since 2011, meaning it curbed economic growth rather than stimulated it. The center estimates it has reduced real GDP growth by about one-third of a percent each year. That’s not insignificant, with GDP growth averaging a little below 2% from 2011 to 2014.

Monetary policy can’t do it alone

While the US government began to rein in its stimulus spending in 2011, the Fed stepped up its efforts because it correctly read the economic trends and saw that the recovery was flagging.

The central bank had already gone full throttle on its usual method for stimulating growth, lowering its target interest rate to essentially zero by the end of 2008, and it could not go lower. So it expanded a policy known as quantitative easing (QE) that it had first adopted during the peak of the financial crisis in 2008. In QE, the Fed purchased large quantities of assets (treasuries at first and later mortgage-backed securities). The aim was to further lower long-term interest rates and spur consumers and companies to borrow and spend more.

No one is quite sure how QE worked, but there is agreement it stimulated growth. Yet despite the Fed’s best efforts, the pace of growth remains well below what we’ve experienced in most recoveries.

Ready for rates liftoff?

Still, growth is growth, and this sluggish, fairly steady improvement in the economy and the declining unemployment rate have raised the question of whether it is time for monetary policy to start its return to normal, sometimes referred to as “liftoff.” The Fed has indicated it would be desirable to begin a return, with rather modest moves.

But is the economy strong enough?

Of particular concern is the negative influence of economic weakness in China and even slower recovery in Europe, where policymakers insisted individual countries adopt fiscal austerity, with results even more dire than in the US.

On the other hand, some have expressed concern that if the Fed keeps rates close to zero, it won’t be able to respond to future economic weakness, should there be any. But this is circular reasoning; it implies the Fed should raise rates in case it needs to push them lower. While the central bank should respond to weakness, it should not become the source of that weakness by tightening policy (lifting rates) prematurely.

We need a fiscal liftoff

The real and much more serious problem is our lopsided macroeconomic policies.

The US would be in much better shape now if Congress had focused more on growth than on reducing the deficit at a time when the economy was weak. We would have had faster, more balanced growth. This would have allowed the Fed to begin its return to normal sooner.

We should be pleased the economy has finally become strong enough for the Fed to consider a need to return to more normal policy. Unfortunately, our tax and expenditure policies – or lack thereof – have made it risky and difficult for our central bank to do this.

But politicians do not seem to be worried about the Fed’s predicament. They can blame it either way: whether liftoff is too early or too late without ever reminding us they created the problem in the first place.

Sheila Tschinkel does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.

Authors: Daily Bulletin

Read more http://theconversation.com/should-the-fed-raise-rates-wrong-question-heres-the-right-one-45813

Business News

Choosing the Right Mini Digger: Factors to Consider

In the vast landscape of construction and landscaping projects across Australia, mini diggers have become indispensable tools. These compact machines pack a powerful punch, offering versatility and ...

Daily Bulletin - avatar Daily Bulletin

Effective Strategies to Generate and Nurture Sales Leads for Business Growth

Boost your business's growth. Discover effective strategies to generate and nurture sales leads! A sales lead refers to an individual or business entity that is potentially interested in purchasing...

Daily Bulletin - avatar Daily Bulletin

Products Made from Petroleum

From transportation to healthcare, petroleum has become an integral part of our everyday lives. This fossil fuel serves as the foundation for a wide range of products that surround us, offering conv...

Daily Bulletin - avatar Daily Bulletin

Tomorrow Business Growth