How the Fed Keeps Its Eye on the Deficit

(Bloomberg Opinion) -- A recurring supply-side dream has been that economic growth will let us balance the budget painlessly. It has happened before. In the late 1990s, when Bill Clinton was president and Republicans controlled Congress, the economy grew faster than expected and briefly eliminated the federal budget deficit. But it does not appear to be happening now.

At the moment both the economy and the deficit are growing. Last year the federal government spent $665 billion more than it raised. This year the Congressional Budget Office projects a $793 billion deficit. Spending has increased, and revenues are lower than they would have been without the tax cuts enacted at the end of last year.

So we are not growing our way out of the deficit. Are we deficit spending our way into growth?

In 2017, President Donald Trump said that two years of higher deficits might be worthwhile as a means of boosting economic growth. His view that deficits are stimulative — that they tend to expand the economy — has plenty of support among economists.

But most economists would register the caveat that raising deficits to boost the economy makes more sense when the economy is weak, as it was in 2009 and 2010, than when it is strong, as it has been over the last two years. The less slack there is in an economy, the more we should expect stimulus to result in inflation rather than in increased production of goods and services.

Yet we should not be too quick to assume that higher deficits are currently raising either economic growth or inflation to a significant degree. That’s because any estimate of the economic effect of changes in the deficit has to account for its interaction with monetary policy.

To see why, assume that deficits stimulate the economy when you leave aside monetary policy. Then consider a counterfactual world in which the deficit were not increasing. In that world -- by assumption -- the economy would be growing less rapidly. Unemployment would be a bit higher and inflation a bit lower.

But in that case, the Federal Reserve would be less worried that the economy is running too hot and more concerned that higher interest rates would tip it into recession. It would therefore be raising interest rates at a slower pace, or not at all.

Monetary policy would, that is, be more expansionary. (You can call it “less contractionary” if you prefer; it makes no difference for my point.) And the more expansionary monetary policy is, all else equal, the lower the unemployment rate and the higher the inflation and output rates are.

Monetary policy, then, offsets the effects of fiscal policy -- not perfectly, but substantially. Trump just noted the connection himself: “I don’t like all of this work that we’re putting into the economy and then I see rates going up.”

It’s important to note, though, that there is no reason to assume that the Federal Reserve is trying to undercut Trump’s policies. The Fed offsets the impact of changes in the deficit even if its policymakers are not consciously trying to do so. The central bank need only respond in roughly consistent ways to trends in unemployment, inflation and other economic variables for its behavior to counteract fiscal stimulus.

So we are probably not getting much higher growth, or inflation, from our increased deficit. What we’re getting instead: Social Security and Medicare benefits for an ever-swelling group of Baby Boomer retirees; a larger military; a modestly improved tax structure that offers a bigger payoff for work, saving and investment. And, of course, a bigger national debt, which comes with an obligation to pay greater amounts of interest.

The good news is that the same process works in reverse. If Congress and the president were to take action to reduce future deficits, any contractionary effect it had on the economy would likely be offset by a more expansionary Fed policy. The bad news is that at the moment, we have a president who favors higher defense spending, lower taxes and continued entitlement growth -- so this possibility is for the time being purely theoretical.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

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