Are Keynesians trying to bring back the Real Bills Doctrine?
By Scott Sumner
Lots of people argue that the Fed would not offset a push for more spending out of Washington. In fact, while that would be technically possible, as a practical matter they have almost no choice in the matter. They are committed to targeting forward inflation at roughly 2%, and that means they must offset fiscal policy. Otherwise their inflation forecasts would drift above 2%. And even if Janet Yellen changed her mind, the others would not go along.
A commenter at TheMoneyIllusion left an interesting question:
Why is it such a bad idea for the Fed to coordinate monetary policy with investments in productivity?
This was in response to my claim that the Fed would offset any new infrastructure spending by the government. The idea to fund productive investments with new money is called the “Real Bills Doctrine”. This was a popular idea in the early part of the Fed’s existence, and may have contributed to the Great Depression.
The basic problem with the Real Bills Doctrine is that it leads to procyclical monetary policy. If monetary policy becomes more expansionary when investment is increasing, then it will tend to be more expansionary in booms than in depressions. In fact, monetary policy should be countercyclical—trying to smooth out the path of NGDP over time.
When Keynesians call on the Fed to accommodate a Congressional push for fiscal stimulus, at a time when unemployment is 5%, they are (unintentionally) bringing back the Real Bills Doctrine. I’m tempted to say that Milton Friedman is rolling over in his grave, but given the state of macro theory over the past 5 years, it’s probably more accurate to say he’s spinning like a top.
Conservatives make a similar mistake when they oppose the Fed’s low interest rate “policy”. The Fed does not have a low interest rate policy. The Fed targets inflation at 2%, and the market determines what interest rate is consistent with that objective. Right now it’s a really low rate. That’s not something the Fed has chosen; they have at most a 1/4% leeway to adjust interest rates at their discretion. Their only real choice is the 2% inflation target.
So here’s my message to all you liberals and conservatives. The Fed has one less degree of freedom than you assume. They are targeting inflation at 2%, and that means they have no ability to accommodate fiscal stimulus, and they have no ability to give savers the sort of interest rates they’d like to earn.
The fact that past inflation is rarely exactly equal to 2% is irrelevant. They set monetary policy such that expected forward inflation is about 2%.