Monetary Policy in the Transition to a Zero Federal Deficit

Abstract

In the United States, eradication of persistent federal deficits has won broad bipartisan support. At the same time, political pressures have mounted to strengthen the Federal Reserve's explicit concern with price stability. Proposals under consideration would require a much narrower focus on the part of Fed policymakers, and could be interpreted as targeting the price level rather than a negligible rate of inflation. The deficit-reduction and price-stability policies should be analysed in combination, as reductions in the real interest rate triggered by lower deficits will have an impact on optimal monetary policy with anti-inflation and stabilization objectives. This paper builds upon the analysis of Orphanides and Wilcox (1996) to evaluate optimal anti-inflation policy under a broader set of circumstances than considered in their work. We consider a monetary authority with two instruments--the funds rate (or rate of base money growth) and the discount rate--with the distinction that only movements of the latter are 'credible' alterations of the Fed's policy stance, reflecting reputational effects. The public forms expectations of inflation given realized inflation and the expected progress toward lower inflation, as evidenced by credible policy moves and the gradual eradication of the fiscal deficit. The interaction between deficit reduction policy and the optimal monetary trajectory is analysed, and the implications for the coordination of these strategies considered via stochastic simulations of the model. The impacts of a price level stabilization target on the Fed and a balanced-budget rule on the fiscal authorities are contrasted with their more flexible counterparts: an inflation target and restriction on deficit spending. Our results indicate that these more stringent political constraints on economic policy could have severe consequences on the ability of the monetary and fiscal authorities to mitigate adverse economic shocks.