I think we are making good progress but if there were to be a negative shock to the economy and I mentioned this in my testimony, starting with very low levels of interest rates, we don't have a lot of room using our traditional tried and true method to respond.

If fiscal policy were more expansionary this neutral level of interest rates, one of the factors that affects what level of interest rates is neutral for the economy keeps it on an even keel. The level would be higher with a different stance of fiscal policy.

“Monetary policy should not have the whole load of getting us out of this phenomenon,” Mr. Greenspan said. “It’s fundamentally a fiscal problem.”

There was once a great deal of work on the optimal monetary-fiscal policy mix. The topic was interesting and the analysis persuasive. Nonetheless the subject seems to be disappearing from the public dialogue; perhaps in ascendance is the notion that—except in extremis, as in 2009--activist fiscal policy should not be used at all. Certainly, it is easier for a central bank to change its policies than for a Treasury or Finance Ministry to do so, but it remains a pity that the fiscal lever seems to have been disabled.

A central bank can use its balance sheet to alter the allocation of credit in the economy. By lending to or buying the securities of private sector entities, central bank credit allocation can cause more resources to flow to those segments of the economy than would otherwise be the case. This deprives other sectors of resources, however, and may distort economic activity in a way that is unproductive. Importantly though, I would not characterize central bank credit allocation as monetary policy, but rather as fiscal policy. As a result, I believe it is appropriate for such actions to be taken only by elected branches of government, not by the central bank.

This is why I have dissented on FOMC decisions to purchase securities backed by home mortgages.

San Francisco Federal Reserve President John Williams said on Friday that low neutral interest rates are a warning sign of possible changes in the U.S. economy that the central bank does not fully understand.

"I see this as more of a warning, a red flag that there's something going on here that isn't in the models, that we maybe don't understand as well as we think, and we should dig down deep deeper and try to figure this out better," he said during a panel discussion at the Brookings Institute in Washington.

Williams, who is a voting member of the Fed's policy-setting panel through the end of the year, has said the central bank should begin to raise interest rates soon but thereafter go at a gradual pace.

He added that the low neutral interest rate had "pretty significant" implications for monetary policy, and put more focus on fiscal policy as a response.

"If we could come up with better fiscal policy, find a way to have the economy grow faster or have a stronger natural rate of interest, then that takes the pressure off of us to try to come up with other ways to do it, like through a large balance sheet or having a higher inflation target," Williams said. "It also means we don't have to turn to quantitative easing and other policies as much."

There has been a significant decline in the long-run neutral real interest rate in the United States over the past few years. This decline in the long-run neutral real interest rate increases the future likelihood that the FOMC will be unable to achieve its objectives because of financial instability or because of a binding lower bound on the nominal interest rate. Plausible economic models imply that the fiscal authority can mitigate this problem by issuing more public debt, although such issuance is not without cost. It is, of course, the province of the fiscal authority to determine whether those costs are worth the benefits that I’ve emphasized today.

The decline in the long-run neutral real interest rate increases the likelihood that the economy will run into the lower bound on nominal interest rates. Accordingly, there is an enhanced risk that the Federal Open Market Committee (FOMC) will undershoot its maximum employment and 2 percent inflation objectives. Fiscal policymakers can mitigate this risk by choosing to maintain higher levels of public debt than markets currently anticipate. I want to be clear at the outset that I am not saying that it is appropriate for fiscal policymakers to increase the long-run level of public debt. I am simply pointing to one benefit associated with such an increase: It allows the central bank to be more effective in mitigating the impact of adverse shocks to aggregate demand.

Fiscal deficits also appeared to be under control before the crisis. According to the Organisation for Economic Co-operation and Development (OECD), general government deficits in 2007 were less than 4 percent of GDP in the United States and the United Kingdom, about 2 percent in Japan, and less than 1 percent, on average, in the euro area. Still, given relatively buoyant economic conditions, governments probably should have been doing more to prepare for the long-term challenge of aging populations, which will boost pension obligations and health-care expenditures in coming years. Moreover, government debt levels were already high in Japan and in some European economies and not particularly low elsewhere. In addition, some euro-area countries that appeared to have strong fiscal positions going into the crisis depended partly on revenue from housing booms that soon went bust.

The combination of increasing debt and depressed output led to rising ratios of debt to gross domestic product (GDP) in many advanced economies and heightened concern about whether the growth in debt could be sustained without unsettling financial markets But fiscal policy also turned contractionary in countries facing less market pressure, such as the United Kingdom and the United States. Governments in both countries embarked on fiscal consolidation programs over the past four years, sharply reducing their structural deficits, and, as a consequence, creating headwinds that slowed the recovery.

With fiscal drag weighing on growth and with private-sector deleveraging also holding back consumption and investment, monetary policy bore the brunt of supporting the economy. With policy rates at or approaching zero, central banks of necessity turned to unconventional policy tools such as large-scale asset purchases and enhanced forward guidance about the future path of policy rates.

Even so, the recovery in most advanced nations has proceeded more slowly than policymakers would have hoped. This sluggishness has been due in part to the severity of the financial shock associated with the crisis and the persistent headwinds to recovery in its aftermath. But the lack of fiscal support for demand in recent years also helps account for the weakness of this recovery compared with past recoveries For instance, at a comparable point in the recovery from the 2001 recession, employment at all levels of government {in the United States} had increased by about 800,000 workers; in contrast, in the current recovery, government employment has declined by about 650,000 jobs.

What lessons can we draw from this experience? The first is that governments need to address long-term challenges and significantly improve their structural fiscal balances during good times so they have more fiscal space to provide stimulus when times turn bad

A second lesson is that, while even if it is appropriate for fiscal policy to play a larger role when policy rates are near zero, policymakers nevertheless may face constraints in implementing fiscal stimulus. This means that central banks need to be prepared to employ all available tools, including unconventional policies, to support economic growth and to reach their inflation targets.

[I]ts important that federal fiscal policy gets done. But I dont believe that the Fed is, in the parlance of pop-psychology, an enabler of what most characterize as Washingtons intransigence on fiscal policy. This position argues that the Fed is somehow too reliable; that because we have the tools to manage a crisis, other institutions will avoid their own areas of responsibility because they can rely on us to pull an economic rabbit out of our hat. If theres no urgency, they can avoid action on politically volatile legislation, and the can gets kicked further and further down the road.

Let me be clear that us doing our jobs doesnt absolve anyone of the responsibility to do theirs. Decisions about taxes, spending, and entitlement programs will always collectively be a political third rail, and monetary policybe it accommodative or fully normalizedwont change that. The idea that the Feds propping up of the economy is letting Congress avoid decision-making doesnt hold; that implies that the only prompt to action would be an economy in freefall, something no one wants. Congress has many reasons to act on fiscal policynot least of which being a growing population and shifting demographics that will see the largest generation in our history moving into old ageand nothing we do to interest rates will alter that reality.

The enabling argument is largely driven by an underlying concern that the Fed has somehow lost its independence, or that its becoming too active a player in the economy. But nothing could be further from the truth. We hold our independence as sacrosanct, because its necessary for us to make the best policy decisions we can. If we step out of our assigned role, we could endanger that independence, and that would fundamentally alter our ability to do our jobs.

"We just need the right stimulative policies, and if fiscal policy could help provide that, then that would make all the accommodative monetary policies that much more powerful,” Federal Reserve Bank of Chicago President Charles Evans said today at an International Monetary Fund seminar in Washington.

“It would lead to greater investment, more customers walking through the doors of all the stores that need that.”

MOORE: There's a lot of criticism about Quantitative Easing and the positions that the Fed has taken, the Fed policy, and on the other end of the street here Congress has been engaging in more and more and more fiscal austerity.
Is it fair to say that we're kind of working at cross purposes here, you know, on one end we're forcing real austere cuts, the economy is slowing while you're doing Quantitative Easing -- it's my thought -- my friend here coming in the door -- it's my thought that we might be able to slow down on Quantitative Easing if we weren't forcing such austerity on the economy.
YELLEN: Well, I agree. I basically agree with your point. As an example over the last year -- I'm sorry, during 2013 -- the CBO estimated that fiscal drag depressed growth by about a percentage point and a half, which is really a pretty significant -- significant drag on growth. And our policies have been trying to offset that, to boost the recovery.
So, yes, in that sense we have been working at cross purposes.

MULVANEY: Chair Yellen, it appears that the FOMC has had at least two special hearings over the course of the last several years regarding the debt ceiling...
So, in light of the fact there've been at least two hearings where the technical aspects or the plans regarding the processing of federal payments have been raised, and the conclusions of both of those that it would not materially impact the conduct or procedures of the Fed, I'll ask you a simple question: Is there a contingency plan in place regarding federal payments -- the making of federal payments in the event the debt ceiling is not raised?
YELLEN: Not to the best of my knowledge.
MULVANEY: Then I'll ask you, Ms. Yellen -- thank you for that -- in the 2011 minutes, which read, "The staff provided an update on the debt limit status, conditions in the financial markets and, most importantly, plans that the Federal Reserve and the Treasury had developed regarding a process of federal payments," what were those plans that had already been developed as of at least August 2011?
YELLEN: Well I mean, we're discussing very technical issues connected with the payment system, for example, would the Treasury put through in the morning ACH payments that they might not have sufficient balances in their account to pay.
MULVANEY: And what would happen in such a circumstance?
YELLEN: Well, in such a circumstance , if they did that, banks would receive instructions in the morning to pay customers amounts that the Treasury wouldn't have in their checking account to make good on. And so their checks would bounce leaving those institutions in a very difficult situation...
MULVANEY: Are the plans that are referenced in the 2011 hearing in writing?
YELLEN: There are -- there are briefings that staff made to the Federal Open Market Committee when we met, when we met about what our plans would be in terms of the responsibilities...
MULVANEY: I understand that, but are the briefings based upon a written document? Are they based on some verbal history at the Fed or the Treasury? Is there a written down plan on these payments?
YELLEN: To the best of my knowledge, there is no written down...
MULVANEY: Given the fact that coming up with a contingency plan would have a great deal of impact on calming the markets in the face of a debt ceiling difficulty, do you think it's a good idea to develop a contingency plan for prioritization of payments in the event the debt ceiling is not raised?
YELLEN: That's a matter that is entirely up to the Treasury. That is not the domain of the Federal Reserve.
MULVANEY: But you have -- you perform the functions for the Treasury through the New York Fed, don't you?
YELLEN: With the Fed's -- with the Treasury's fiscal agent.
MULVANEY: If they asked you to do it, could you?
YELLEN: It is not up to us to develop a plan concerning what bills would be paid.
MULVANEY: If the Treasury asked you to create a program to put into place through the New York Fed could you do it?
YELLEN: I don't know that we could do that.
MULVANEY: Do you think it would be a good idea to do that?
YELLEN: Treasury submits to us every day a set of payments to make.
MULVANEY: I understand.
Let me finish with this, Ms. Yellen.
I appreciate that.
We have asked for the records from the Fed, specifics related -- identified in the meeting from the New York Fed. The New York Fed has told us we cannot have have them until they get permission to give them to us from the Treasury.
In light of your earlier comments to Ms. Bachmann and Ms. Posey regarding Fed independence, are you concerned about having to ask the Treasury for permission to give information to Congress?
YELLEN: Well, the Federal Reserve acts as the Treasury's fiscal agent, and in that case we take instructions from the Treasury and are merely acting as their agent. That's one of our roles to serve as the fiscal agent of the Treasury. It is not a monetary policy role.

To this list of reasons for the slow recovery--the effects of the financial crisis, problems in the housing and mortgage markets, weaker-than-expected productivity growth, and events in Europe and elsewhere--I would add one more significant factor--namely, fiscal policy. Federal fiscal policy was expansionary in 2009 and 2010.18 Since that time, however, federal fiscal policy has turned quite restrictive; according to the Congressional Budget Office, tax increases and spending cuts likely lowered output growth in 2013 by as much as 1-1/2 percentage points. In addition, throughout much of the recovery, state and local government budgets have been highly contractionary, reflecting their adjustment to sharply declining tax revenues. To illustrate the extent of fiscal tightness, at the current point in the recovery from the 2001 recession, employment at all levels of government had increased by nearly 600,000 workers; in contrast, in the current recovery, government employment has declined by more than 700,000 jobs, a net difference of more than 1.3 million jobs. There have been corresponding cuts in government investment, in infrastructure for example, as well as increases in taxes and reductions in transfers.

People don't appreciate how tight fiscal policy has been. At this stage in the last recession, which was a much milder recession, state, local and federal governments had hired 400,000 additional workers from the trough of the -- of the recession. At the same point in this recovery, the change in state, local and federal government workers is minus 600,000. So there's about a million workers difference in how many people have been employed at all levels of government. So fiscal policy has been tight, contractionary, so there have been a lot of headwinds.

I used to say that the United States was the best-looking horse in the global glue factory. Now, I firmly believe we are the most fit stallion or filly on the global racetrack: Our companies are the most financially prepared and most productively operated they have been at any time during the nearly four decades since I graduated from business school. What is holding them back is not the cost or the availability of credit and finance. What is holding them back is fiscal and regulatory policy that is, at best, uncertain, and at worst, counterproductive. Without fiscal policy that incentivizes rather than discourages U.S. capex (capital expenditure), this accommodative monetary policy aimed at reducing unemployment (especially structural unemployment) or improving the quality of jobs is rendered flaccid and less than optimally effective. And as to the housing markets, prices are now appreciating to levels that may be hampering affordability in many markets.