A perceptive, progressive politician I know once described economists as "the people who tell you why you can't do the things you want to do." That's not wrong, but there are substantial changes brewing in the way economists think about two of the most critical areas of economic policy, monetary policy run by the Federal Reserve and fiscal policy run by the federal government. Moreover, they're progressive changes rationales to do the things we want (and need) to do to help those left behind.

In the case of monetary policy, that means running high-pressure labor markets. In the case of fiscal policy, it means recognizing that deficit-reduction is not always a near-term priority.

The data in the figure below is at the heart of both changes: Interest rates and inflation have been low and stable for many years. Inflation has averaged 1.7 percent since the mid-1990s. (This is core inflation, the Federal Reserve's preferred gauge, which leaves out volatile energy and food prices.) That has contributed to low interest rates, since when inflation is expected to remain low, lenders demand less of a hedge against it.

On monetary policy, the unemployment rate has been below the rate the Fed considers consistent with stable inflation for a few years. That is, according to their own estimates, the tightness of the labor market should be pushing up prices. But it isn't. So, to their credit, the Fed has decided to keep their feet off the brakes for a while: They're not raising the benchmark interest rate they control (a good example of the interaction between low inflation and low interest rates). A recent Bloomberg News article nicely summarized the Fed's more tolerant approach as a "whites of their eyes" strategy, meaning they won't preemptively raise rates as insurance against a future rise in inflation. Instead, they will wait until it's clear that inflation is picking up.

Doesn't this risk getting behind the curve and letting inflation spiral out of control a la the 1970s (see figure above)? That can't be ruled out, but such a risk is relatively low, given how stable both actual and expectedinflation have been for years now. If anything, the Fed is appropriately concerned about inflation being too low even as the economy has closed in on full capacity, they've been undershooting their inflation target of 2 percent.

Share this articleShare

Any inflationary risks must be weighed against the risk of unnecessarily raising interest rates and thereby preventing a robust labor market for getting more people employed. Extensive research has shown that it takes persistently tight labor markets to generate gains that reach low and moderate income workers, both in terms of wages and employment opportunities. So the first big change is that, with inflation low and steady, the Fed can tap these benefits by allowing the high-pressure labor market to help working-class households.

From a fiscal perspective, low interest rates mean that deficit reduction is less urgent and does not need to be a top priority in the near term. That doesn't mean deficits don't matter, and we should be a lot smarter about what we spend borrowed money on. Tax cuts for the wealthy are a big waste. Investments in anti-poverty programs, productivity-enhancing human and physical capital, and offsetting recessions are not.

Low rates imply at least three important things. One, public borrowing isn't "crowding out" private borrowing. If the government was competing with the private sector for loanable funds, interest rates would be higher. Second, as long as the interest rate stays below the growth rate, the costs of sustaining our debt level is manageable, since growth enables us to service existing debt (though tax cuts, of course, make this harder). Third, we can prioritize more pressing problems above near-term deficit reduction, including climate change, opportunities for those left behind even at full employment (say through wage and work supports), and fiscal stimulus for when growth slows down.

In other words, low interest and inflation rates offer policymakers the chance to pursue some positive actions that higher rates would preclude. The Fed can allow full employment to persist and lift those who depend on full employment; the federal government can make public investments in people and places that need the help.

There are, of course, caveats.

Inflation could rise and push up interest rates, but that risk seems low. Remember, the Fed's been missing its target on the downside. Also, the issue isn't just faster inflation; going from below 2 to above 2 wouldn't be a problem (in fact, that would be a good thing, since the Fed's goal is to hit 2 percent inflation on average). It's 1970s-style spiraling inflation that's the worry, and the last 30 years of data render that possibility unlikely.

Fiscal policy is more problematic, because while economists are rethinking the urgency of deficit reduction (e.g., listen to former Congressional Budget Office director Doug Elmendorfer's comments here), politicians haven't felt the negative consequences of rising public debt for many years. They may conclude that we never have to pay for anything again. But the fact that deficit reduction doesn't need to be a top priority doesn't mean it's not a priority at all. Eventually, whether through economic or political channels (or both), it will be impossible to support the programs we want and need if they're increasingly deficit financed.

For now, though, the reality of persistently low-inflation and interest rates creates opportunities to help a lot more people with full-employment-oriented monetary policy and less deficit-obsessed fiscal policy. Whether we take advantage of such opportunities is, of course, yet to be seen.

QUESTION : Why are economists rethinking fiscal and monetary policy?