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This edition was written by Tristan Loa, Andrew Rosin, Jack Spira, and David Wessel.
Discretionary fiscal policy, even when successful in stimulating growth and minimizing economic losses, is imperfect. For example, despite substantial stimulus, the U.S. economy experienced years of high unemployment following the Great Recession and record inflation following the COVID-19 recession. Karen Dynan and Douglas Elmendorf of Harvard University find that automatic fiscal stabilizers—stimulus that adjusts continuously based on economic conditions—would have provided more fiscal stimulus during the Great Recession and, ultimately, generated faster GDP and employment growth than discretionary fiscal policy. Automatic fiscal stabilizers would have provided less fiscal stimulus during the COVID-19 recession, leading to lower inflation and somewhat higher unemployment rates compared to discretionary fiscal policy. The cumulative budgetary costs of these automatic fiscal stabilizers would have totaled $4.7 trillion between the Great Recession and the COVID-19 recession, about 25% less than the $6.4 trillion the government actually spent. At the same time, however, automatic fiscal stabilizers provided less targeted stimulus than discretionary fiscal policy, both in terms of the financial problems they addressed and the specific households, businesses, and state and local governments they benefited.
Analyzing 190 metropolitan statistical areas from 1994 to 2022, Nina Biljanovska of the International Monetary Fund and co-authors find that overvalued housing markets—those where price-to-rent ratios were highest relative to their long-term trend—experienced an additional 0.7 to 1 percentage point decline in real house prices 12 quarters after a 25-basis point interest rate hike. They also find that in high price-to-rent ratio markets, the share of newly originated loans for non-owner-occupied (investor) homes declined more following a Fed tightening cycle than in less overvalued markets. The authors interpret this pattern as evidence that investor demand reacts first to monetary tightening, triggering price declines that later temper the expectations of more optimistic owner-occupiers. The authors also find asymmetry in the effects of monetary policy, with contractionary monetary policy at least twice as effective in mitigating housing market overvaluation as expansionary policy is in exacerbating it. These results suggest that monetary policy can play a significant role in stabilizing fluctuations in overvalued asset prices.
How high can the federal debt rise? Constructing a model in which a government’s fiscal policy responds automatically to changes in macroeconomic conditions, Vadim Elenev of Johns Hopkins, Tim Landvoigt of Penn, and Stijn Van Nieuwerburgh of Columbia define a new measure of fiscal capacity, an “austerity threshold” representing the debt-to-GDP ratio above which a government must raise budget surpluses to avoid defaulting on its debt in any possible scenario of future shocks. They find the level of this threshold depends on the method of austerity employed: tax hikes reduce labor supply and raise inflation, while spending cuts reduce demand and inflation, allowing interest rates to fall. Calibrating the model with U.S. data, the authors estimate a threshold of 189% of GDP under tax austerity and 174% under spending austerity. However, when policymakers may switch between tax hikes and spending cuts—say, with each change in the ruling party—uncertainty about the method of austerity dramatically lowers the threshold to 120%, since swings in interest rates when switching from one regime to the other can cause extreme volatility in the price of government debt.
Q: “What is your explanation for why the job market is weakening right now? And what will this rate cut do to improve the job market?”
A: “So I think there are two things affecting the job market. And one of them is just a dramatic reduction in the supply of new workers. And that’s two things. That’s declining labor-force participation, which is a cyclical thing, and then there’s declining immigration, which is just a big policy change that actually began in the last administration, and it has been accelerated now. So a big part of the whole story is that supply side story. In addition, labor demand has declined…" says Jerome Powell, Chair of the Federal Reserve.
"It’s mostly a function of the change in supply. So the question then, is, what does our tool do, which supports demand? When you’re in a situation where job creation, if you adjust for likely overcounting in the way that BLS does its work, is pretty close to zero – if you’re creating zero jobs, if it’s in equilibrium… it’s a pretty curious balance. So, I thought, and many of my colleagues thought, that it was appropriate for us to react by supporting demand with our rates.
And we’ve done that. We’ve reduced so that rates are looser. I wouldn’t say that they’re accommodative right now, but they’re meaningfully less tight than they were. And that should help so that at least the labor market doesn’t get worse. Though it’s a complicated situation. And some people argue that this is supply and we really can’t affect it much with our tools, but others argue, as I do, that there is an effect from demand, and that we should use our tools to support the labor market when we see this happening.”
Join us for an event
The Hutchins Center on Fiscal and Monetary Policy invites you to attend the event, "The Outlook for the Economy and Monetary Policy" with Fed Governor Lisa Cook on November 3, from 2:00 p.m. to 2:50 p.m. EDT. Both in-person and livestream attendance options are available.
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