Economix Blog: The Fed vs. the Fiscal Cuts: Not a Fair Fight

CATHERINE RAMPELL

Dollars to doughnuts.

Since the financial crisis began, the Federal Reserve has taken the lead on stimulating the economy. It starting easing long before the Recovery Act was even a twinkle in Congress’s eye, and it has continued its stimulus efforts in the last couple of years to counteract fiscal tightening while the Recovery Act was petering out. As Mervyn A. King, the governor of the Bank of England, explained this week, central banks around the world have pursued monetary easing to offset fiscal tightening.

The problem is that fiscal tightening is now a much bigger potential negative for the economy than monetary easing is a positive.

The Fed announced today that it would provide more stimulus, by purchasing $45 billion in long-term Treasuries each month after its continuing “Operation Twist” concludes this month. This was welcome news to the markets, which have been clamoring for the Fed to do more, even though the marginal returns to more Fed stimulus get smaller and smaller. The first big injection of money into the economy does a lot; the second, not quite as much; the third, much less; and so on.

Meanwhile Congress is contemplating fiscal tightening that is much more potent than the Fed’s easing.

Forecasters have estimated that all the spending cuts and tax increases scheduled for the end of the year would shave around 3 to 3.5 percentage points from output growth next year. Few expect Congress to let this happen, of course.

Still, the policy compromise that many insiders do anticipate — eliminating most of the draconian spending cuts scheduled for 2013, extending the Bush-era tax cuts for all but the highest earners, and allowing the payroll tax holiday and emergency unemployment benefits to end as scheduled — will probably shave 2 to 2.5 percentage points off output growth early next year, according to Charles Dumas, chairman of Lombard Street Research. To put that in context, output growth for 2012 is shaping up to be only about 1.7 percent.

It’s no wonder that Ben S. Bernanke, the Fed chairman, has urged Congress to engage in more stimulus. More recently, he pleaded with them to at least not engage in the anti-stimulus that austerity measures amount to. The Fed has been going into overdrive, but even the most aggressive monetary policies are unlikely to reverse the output damage that severe fiscal tightening is expected to cause.

Article source: http://economix.blogs.nytimes.com/2012/12/12/the-fed-vs-the-fiscal-cuts-not-a-fair-fight/?partner=rss&emc=rss