Speech by Governor Brainard on monetary policy in a time of uncertainty
January 17, 2017 / Source: FRB
Governor Lael Brainard
At the Brookings Institution, Washington, D.C.
January 17, 2017
Monetary Policy in a Time of Uncertainty
There are many sources of uncertainty affecting the trajectory of the U.S. economy and, by extension, the appropriate path of monetary policy. In particular, there has been speculation about significant changes to fiscal policy of late, although the magnitude, composition, and timing of any fiscal changes are as yet unknown and will depend on the incoming Administration and the new Congress as well as the vicissitudes of the budgeting process. Even once any changes are enacted, uncertainty will remain about their effects on the overall economy. It thus seems possible that monetary policy could be affected for some time by uncertainty surrounding fiscal policy and its effects on the economy.1
Macroeconomic Outcomes Are Difficult to Predict
Before I turn to the possible effects of fiscal policy, it is helpful to remind ourselves of the immense uncertainty that accompanies any attempt to forecast future economic developments. Many possible surprises could materially affect the future path of the U.S. economy, such as shocks to the price of oil, the foreign economic outlook, the rate of productivity growth, the sentiment of households and businesses, financial stability, and fiscal policy, to name a few. The resulting uncertainty makes it difficult to predict the future path of activity, unemployment, and inflation.
By statute, the Federal Reserve is mandated to conduct monetary policy to promote the long run goals of maximum employment and stable prices. In today's framework, the Federal Open Market Committee (FOMC) has defined stable prices to mean 2 percent inflation. The FOMC adjusts the stance of policy in light of incoming economic information and its implications for the outlook. Uncertainty about future employment and inflation naturally translates into uncertainty about the path of future monetary policy.
One useful measure of uncertainty is the magnitude of forecast errors, or the extent to which macroeconomic outcomes have differed from professional economic forecasters' expectations.2 Over the past 30 years, outside forecasts of the unemployment rate four quarters ahead have missed the actual unemployment rate by more than 3/4 percentage point in either direction one-third of the time. Since notable departures from forecast values of unemployment and inflation occur with some frequency, it should not be surprising that the associated forecasts of interest rates have a similar track record. One-third of the time over the past 30 years, outside forecasts of the level of short-term interest rates four quarters ahead have been above or below the actual level by more than 1-1/4 percentage points.3 Thus, it is important to keep in mind that all macro forecasts and projections of monetary policy are subject to considerable uncertainty, as they are based on information at a point in time, and actual developments could well evolve much differently.
Fiscal Policy Considerations
Among the many factors that can affect the aggregate economy and, by extension, monetary policy, a possible shift in fiscal policy has attracted the attention of both economic forecasters and financial markets of late. Among forecasters surveyed by Blue Chip Economic Indicators, for 2017, 44 percent indicated that they had raised their forecast of inflation and 47 percent had raised their forecast of gross domestic product (GDP) growth because of the recent U.S. election results, although on average forecast changes were modest. Markets have also reacted, and many have interpreted these changes as reflecting expectations of more expansionary fiscal policy in the coming years than previously expected.
In thinking about fiscal scenarios, forecasters have several historical episodes on which to draw. For example, following the 1980 elections, tax cuts were enacted, and defense spending rose. Federal fiscal deficits, adjusted for the cyclical state of the economy, increased by roughly 2-1/2 percentage points of GDP from the period before the elections to six years following the elections, federal debt held by the public increased from about 25 percent of GDP to nearly 40 percent, and the current account deficit widened.4 Following the 2000 elections, similar fiscal changes resulted in an increase in the fiscal deficit of close to 3 percentage points of GDP over the first six years of the new Administration on a cyclically adjusted basis. Of course, there are important differences in today's conditions relative to these historical settings, including the economy's cyclical position, current and projected levels of indebtedness, the relative position of the global economy, and monetary policy settings.
As of today, there is substantial uncertainty about the magnitude, timing, and composition of any possible change in the stance of fiscal policy. It is instructive to contemplate the important dimensions along which fiscal policy and its effects might vary as well as their implications for monetary policy. In addition to the critical size and timing issues, there are four key dimensions: (1) the composition of policy changes and their relative effects on aggregate demand and aggregate supply, (2) the distance of the economy from full employment and 2 percent inflation, (3) the divergence in the cyclical position of the U.S. economy relative to foreign economies, and (4) the amount of fiscal policy space.
Different types of policies can generate very different economic responses and have implications regarding both the amount of aggregate economic stimulus per fiscal dollar and also whether the effect is predominantly to raise aggregate demand or also to expand the supply potential of the economy. Generally, fiscal stimulus that expands spending and investment directly or is targeted to households and businesses that have the greatest propensity to spend rather than save can be expected to generate the largest response in aggregate demand.5
Focusing first on policies that affect only aggregate demand, temporary demand-based fiscal expansions can speed recovery when the economy is some distance from full employment and target inflation, particularly if conventional monetary policy is constrained by the effective lower bound. But when the economy is either close to or at full employment and inflation is converging to or at its target, additional fiscal demand will more likely result in inflationary pressures. Thus, fiscal expansions that affect only aggregate demand and are enacted when the economy is near full employment and 2 percent inflation are relatively less likely to sustainably boost economic activity and relatively more likely to be accompanied by increases in interest rates.