Economist Writing Every Day

Trump wants both low taxes and low interest rates. I hope that he doesn’t get it.

For the last ten days of my Principles of Macroeconomics course, I emphasize the aggregate supply and aggregate demand model coupled with monetary offset. What’s monetary offset? It says that, given some target and administrative insulation, the Federal Reserve can ‘offset’ the aggregate demand effects of government fiscal policy. It’s what gives us a relatively stable economy, despite big fiscal policy changes from administration to administration.

For example, if the Fed has a 2% inflation target, then they have an idea of how much total spending in the economy (NGDP) must change. If the federal government changes tax revenues or spends more, then the Fed can increase or decrease the money supply in order to achieve the NGDP growth rate that will realize their target. For example, after the 2017 Tax and Jobs Act lowered taxes, the Federal Funds rate rose in 2018. The effect of the tax cuts on NGDP were *offset* by monetary policy tightening to keep inflation near 2%.

If the Fed doesn’t engage in monetary offset, then fiscal policy has a bigger impact on the business cycle, causing more erratic bouts of unemployment and inflation. The economy would be less stable. Importantly, monetary offset  works in both directions. It prevents tight fiscal policy from driving us into a national depression, and loose fiscal policy from fueling inflation. That’s good since politicians face an incentive/speed/knowledge/political problem.

Personally, I would love lower taxes and lower interest rates. I’d get to enjoy more of my income rather than sending it to uncle Sam and, after refinancing, I’d pay less to service my debts. BUT, the same is true for everyone else too. All of that greater spending would result in higher prices and persistent inflation.

Right now, low taxes and high spending meant that the government is running persistent budget deficits – it’s borrowing money. That’s stimulative. If the Fed lowers interest rates, individuals would refinance and borrow more. That’s also stimulative. If both fiscal and monetary policy are stimulative as part of achieving the Fed’s target, then there is nothing wrong. But deviation from that policy goal brings economic turbulence.

This analysis implies an impossible trinity of macroeconomic stability (not the one from international trade):

1. Loose Fiscal Policy
2. Loose Monetary Policy
3. A Politicized Central Bank

You can’t have all three in a stable equilibrium.

1. If the US Treasury implements loose fiscal policy, then it can lean on the politically responsive Fed in order to adopt tighter monetary policy and prevent inflation.
2. Similarly, if the US Treasury adopts tight fiscal policy, to repay debt for example, then it can lean on the politically responsive Fed in order to adopt looser monetary policy and prevent depression.
3. Finally, if both Fiscal and Monetary Policy are loose, then it must be that it is part of the policy prescribed by achieving the monetary policy target of a politically insulated central bank.

If a government tries to pursue all three, then an inflation and unemployment spiral will occur akin to that of the 1970s. Famously, the presidents of the 1960s and 1970s leaned on the Fed Chairs in order to finance the Great Society programs and the Vietnam war. The impossible trinity of macroeconomic stability doesn’t say that you can’t have all three of the above items ever. It says that you can’t have all three and avoid macroeconomic disturbance. Of course, this scheme identifies the maximum number that you can have from the above list. There is nothing that says a country must have two.

Currently in the US, fiscal policy is loose, monetary policy is relatively neutral, and the Fed has balked at additional interest rate cuts. However, President Trump has made very clear that monetary policy is tighter than he prefers – and he’s made no bones about trying to intimidate Jerome Powell and interviewing potential successors who will be compliant. I doubt that President Trump will be successful in politicizing the Fed, even if his Chair pick is confirmed. I have a great deal of trust in the Fed’s institutional framework to prevent singular bad/foolish actors. Hopefully, I’m right.

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PS: Below left is the real federal funds rate and the government deficit as a percent of GDP. Below right is the inflation and unemployment rates. When both fiscal and monetary policy were loose in the 1970s (and presidents were pressuring the Fed Chairs), both unemployment and inflation were high.