The Fed and the Fiscal Cliff

One interesting footnote to the Fed’s decision today to introducequantitative thresholds–that it expects to keep rates low at least as long as unemployment exceeds 6.5%, their inflation forecast doesn’t exceed 2.5%, and long term inflation expectations are well anchored–relates to the fiscal cliff.

The fiscal cliff creates a risk to the outlook that is unusually sizeable in a short timeframe.  First, while some of the cliff is phased in over time (a “fiscal glide”), there are significant upfront effects that will be reinforced by potentially sharp moves in financial markets.  This suggests the pass-through to the real economy would be rapid.  Also, whatever the eventual outcome, uncertainty due to the fiscal cliff is highest over the next few weeks or months.  This is not a combination that monetary policy is well designed to address.  With interest rates at the lower bound, evidence that successive rounds of quantitative easing are having a diminishing impact on the economy, and the long lags through which monetary policy feeds through to the economy, the Fed has limited short-term ability to buffer the economy if we go off the cliff.  But there will still be a monetary policy offset through changing expectations of future policy.  If we go fully off the cliff, and growth plunges, the yield curve should flatten (bond prices rise) on revised expectations of easy-for-longer monetary policy and safe-haven flows, providing a brake against the worsening of financial conditions that would result.  Conversely, a good deal brings forward expectations of the timing of the recovery.

What’s different now?  The new approach creates automatic adjustment by markets.  Now when a shock hits the economy, we change our forecast and reset expectations accordingly; we don’t need a confirming change in guidance from the Fed.  Chairman Bernanke emphasized this point in today’s press conference.

Yesterday I blogged about the seeming disconnect between how NY and DC look at the fiscal cliff.  My bottom line was that while there was an upside to markets if a comprehensive deal was agreed that included the debt limit, the markets may be underestimating the risk of outcomes that leave the debt limit unaddressed and cause substantial uncertainty to persist into 2013.  This is still the case, but if the Fed’s new approach and the clarity it provides results in a stronger or quicker market response, then monetary policy may be a more effective buffer against a negative cliff shock.  In any event, it will be an early test of the new approach.

This piece is cross-posted from Macro and Markets with permission.