Expectations, Monetary Policy, and Austerity

Mike Konczal has a piece at Wonkblog arguing that we are witnessing a great natural experiment that will help us determine whether expansionary monetary policy can offset contractionary fiscal policy:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

Paul Krugman agrees.

Ryan Avent responded, noting that most monetary policy advocates were encouraged by the recent Fed actions, but almost no one argued that they would be sufficient.

Ryan Avent's post is worth reading in full, but I would add one thing. Market monetarists (and other monetary policy advocates) believe that the most important aspect of monetary policy is the expectations channel and the explicit statements from the Federal Reserve. What Ben Bernanke says is as important as what the FOMC does. With that in mind, it is worth looking at Bernanke's actual comments about fiscal tightening. Here is what he said about the fiscal cliff:

I hope it won't happen, but if the fiscal cliff occurs, as I've said many times, I don't think the Fed has the tools to offset that event.

And here is what he said about the sequester:

Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant.

What Bernanke was saying was that the public shouldn't expect the Federal Reserve to increase monetary stimulus in a manner sufficient to offset fiscal tightening and keep nominal spending on track. For those who believe the expectations channel is paramount, the fiscal tightening of 2013 should damage the recovery, because Ben Bernanke said it would.

The joke is that Ben Bernanke agrees with Mike Konzcal that monetary policy can't offset fiscal tightening. The market monetarists just believe they are both wrong.

I don't want to pretend this doesn't set a really high bar for falsifiability of market monetarist ideas, it does. I also agree with Mike Konzcal, that as a practical matter, active fiscal stimulus combined with a federal reserve that tolerates higher inflation is probably a more credible way to boost nominal spending expectations. But as a theoretical matter I don't think the first few months of 2013 settle anything.