Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Friday, February 9, 2024

Does high-interest policy constitute fiscal stimulus?

I haven't had much time to blog lately, but I thought I'd weigh in on an interesting discussion I see brewing in Twitterland. The macroeconomic backdrop of the story is how the U.S. economy grew so rapidly in 2023 in the face of a dramatic increase in the Fed's policy rate. Over the period March 19, 2022 - July 27, 2023, the IORB rose from 0.40% to 5.40% and has remained there ever since. In 2023, RGDP grew at 2.5%. PCE inflation in 2023 came in at 3.7% (a decline from the previous year's 6.5%). The unemployment rate remains low (around 3.5%). What's going on here? What happened to the recession so many were predicting?

One idea floating around out there is that high interest rate policy constitutes of a form of fiscal stimulus. Here's Stephanie Kelton expressing the idea:

And here's my friend Sam Levey suggesting the same thing:
For ears attuned to conventional wisdom, this idea sounds bizarre and counterintuitive. But I think there's a way to reconcile these different views. The first step toward reconciliation is to understand the difference between increasing the interest rate and keeping it elevated. That is, we need to make a distinction between change and level.

I think *changes* in the policy rate seem to work the way conventional wisdom dictates (i.e., lowering aggregate demand through a variety of channels). One important channel works through the wealth effect (e.g.):

Once the policy rate remains stable and the transition dynamics work their way through ("long and variable lags"), the higher policy no longer appears contractionary. In fact, high interest rate policy may very well be expansionary, as Stephanie and Sam suggest. How might this work?

In the class of economic models I work with (e.g., see here), monetary (interest rate) policy and fiscal (tax & spend) policy are inextricably linked through a consolidated government budget constraint. A *change* in the policy rate has all the textbook effects of monetary policy--but only in the "short-run." So, for example, while an *increase* in the interest rate puts downward pressure on the price-level, the disinflationary force is transitory (the P-level remains permanently lower if the policy rate remains permanently higher, but the rate of change of the P-level in the long-run remains unchanged).

At least, this is what is predicted to happen if the fiscal policy framework is "Ricardian." A Ricardian fiscal policy is one in which the path of the primary deficit/surplus adjusts over time to anchor a given debt-to-GDP ratio. A Ricardian fiscal regime is often just assumed in economic models. This assumption seems hard to reconcile with the fact that Congress does not appear to implement offsets to Fed policy. At least, it does not appear to do so immediately. It is, however, possible that the offsets (higher taxes, lower spending) are postponed to the future (perhaps after our representatives become alarmed by posts like Marc Goldwein above).

But there is another possibility. It could be that the fiscal regime is "Non-Ricardian." A Non-Ricardian fiscal policy does not anchor fiscal policy in the way a Ricardian regime does--it does not offset higher interest expense (and higher interest income for bond holders) with higher future taxes and/or lower future spending. To finance the added interest expense, it just lets the Treasury issue nominal Treasury securities at a faster pace. If the Fed keeps its policy rate steady (at its higher level), then this additional flow of private sector wealth is likely to manifest itself as stimulus (higher inflation, if the economy is at full employment). Is this where we're at today?

Of course, the Fed is likely to react to the situation described above by *increasing* its policy rate again. But if fiscal policy is Non-Ricardian, the disinflationary pressure induced by the rate change will eventually dissipate. Indeed, it will result in an even higher rate of inflation in the long-run. This is related to the "Unpleasant Monetarist Arithmetic" argument put forth by Sargent and Wallace over 40 years ago; see here: Is it Time for Some Unpleasant Monetarist Arithmetic? And in case you believe this scenario is only hypothetical, consider this paper on the Brazilian hyperinflation: Tight Money Paradox on the Loose: A Fiscalist Hyperinflation. (Note: this is not to suggest that the U.S. is Brazil.)

As always, please feel free to share your thoughts below.