A reduction in both fiscal and monetary stimulus

By Edward Harrison On Jul 9, 2010

I have argued that both fiscal and monetary stimulus would be withdrawn sooner than most people expected. Here’s how I put it in March (emphasis added):

I expect the following to occur:

Public pressure to withdraw monetary and fiscal stimulus will work and stimulus will be reduced quicker than many anticipate – beginning sometime in early 2010. The Fed has already said it will stop buying mortgages in March and the Obama Administration is now focused on deficit reduction as evidenced by the paltry jobs bill just passed.

The fiscally weak state and local governments will therefore receive little aid from the federal government. This will result in budget cuts, tax increases, and layoffs by the end of Q2 2010.

At the same time, the inventory cycle’s impact on GDP growth will attenuate. By the second half of 2010, inventories will not add considerably to GDP.

Meanwhile, the reduction of Fed support for the mortgage market will reveal weaknesses there. Mortgage rates may increase, decreasing housing demand.

Employment will be weak in this environment, leading to another spate of defaults and foreclosures.

The foreclosures and weak housing demand will pressure house prices and weaken lender balance sheets, especially because of second-lien exposure. This will in turn reduce credit growth.

I expect the weakness in GDP from this scenario to be evident sometime in the second half of 2010.

–The mindset will not change; a depressionary relapse may be coming, Mar 2010

And indeed, this seems to be the case. Right now, we are in a fragile recovery. All indications are that the pace of economic growth is slowing. While I think it premature to call for a double dip, some are doing so. I still think the odds favour double dip and the change in monetary and fiscal policy is a large part of why.

The one factor I have got wrong so far is mortgage market yields, which are at record lows and supportive of recovery. But that owes to Fannie and Freddie. I still have hope for a multi-year recovery because, while employment is weak, the second wave of defaults is not yet upon us.

Nevertheless, on fiscal policy, we are clearly moving in a non-stimulative direction. Although the Obama Administration sounds like a stimulus dove now, I don’t have to go back far into my archives to late 2009 and early 2010 when the tone was quite hawkish. Here are a few examples

Some believe this is a repeat of the 1930s and a big mistake. That’s neither here nor there because the deficit hawks are out in force. The mantra seems to be "stop spending, stop spending, stop spending." This is having its effect.

But, while most have focused on fiscal policy’s role in this, increasingly the worry has turned to monetary policy.

Remember, the Federal Reserve has already taken extraordinary measures which have called its independence into question.

[T]he Federal Reserve has been acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line…

–The Fake Recovery, Apr 2009

Until recently, many were worried the Fed’s monetary policy was inflationary, not deflationary. At a minimum, the "Audit the Fed" movement has probably caused the Fed to pull back on stimulative policy initiatives. I doubt the Fed is going to start buying private sector debt or municipal bonds with a new QE program… at least not yet.

I think Scott Sumner gets the mood right when he writes:

I want the Fed to raise interest rates by setting a much higher price level or NGDP target. But alas, the Fed seems horribly confused about this issue. Only if the period of zero rates was linked to economic conditions in such a way as to increase inflation expectations, would the policy have any stimulative effect. I’ll address this issue in another post later today…

For 18 months I have been bashing the Fed’s interest on reserve program. And a zillion commenters have insisted I don’t know what I am talking about. “The Fed knows what it is doing better than you, Sumner.” “They would never adopt a contractionary policy during a severe recession.” “It’s all in your imagination.” OK, but isn’t this an admission that a lower IOR would be expansionary? Robert Hall and Susan Woodward were right last year. The Fed’s policy was contractionary, and still is…

The executive and legislative branches are literally pulling out their hair trying to think of stimulus packages that won’t blow up the deficit. And here is Bullard basically saying, “Yeah, we could do “plenty” more to boosting AD without increasing the deficit by one cent, but we don’t want to. How did the world’s greatest power get into a position where there appeared to be an easy way out of 9.5% unemployment, but we weren’t doing it solely because of an independent central bank? And don’t tell me there are other reasons why AD might not solve our problems. That’s not what I said. I said Congress and the president think more AD would solve our problems. If they could boost AD without increasing the deficit they would do so in a heartbeat. The US isn’t refraining from additional stimulus because Obama, Reid and Pelosi are sudden converts to freshwater economics, we are refraining from boosting AD because they do not control the only policy tool that is able to do so without blowing up the deficit.

PS. I don’t like to use profanity here. But if Obama and Congress understood the meaning of Bullard’s statement (which is unlikely) they would probably interpret it as the Fed blowing them a giant F*** ***. I’m sure Bullard didn’t mean it that way, but I don’t see any other interpretation.

–The Fed fesses up (What will my critics say now?)

Is Sumner right?