You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.
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Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul VolckerEven the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

[T]here is a risk that an extended period of low interest rates may distort long-run investment decisions; lead to a search for yield that results in excessive risk-taking; and contribute to the development of asset price bubbles.

In my view, these limitations are significant, and they lead me to believe that we should look to fiscal policy to play a more important role in responding to the spillover from a financial crisis. In contrast to monetary policy, fiscal policy can work effectively even when the financial system is impaired, and its effects are felt more broadly across the economy. My own view is that monetary policy may be a good first line of defense, but should not be relied upon too heavily for too long. Of course, we would have to rely less on monetary policy to respond to financial crises if we could, instead, take measures that would reduce the likelihood or severity of financial crises.

History may place blame on this or that president or on Congress for failing to act.  But, ultimately, the responsibility to solve these looming fiscal issues rests with voters.  In the end, the person who is responsible for the $83.9 trillion meltdown that is happening before our very eyes—the person responsible for saddling each of your children and every other person you love with $280,000 in debt—is the one you look at in the mirror each morning.   

[S]cenarios that project large deficits also project rapid growth in the outstanding government debt.  The higher levels of debt in turn imply increased expenditures on interest payments to bondholders, which exacerbate the deficit problem still further.  Thus, a vicious cycle may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits.  According to the CBO projection that I have been discussing, interest payments on the government's debt will reach 4-1/2 percent of GDP in 2030, nearly three times their current size relative to national output.  Under this scenario, the ratio of federal debt held by the public to GDP would climb from 37 percent currently to roughly 100 percent in 2030 and would continue to grow exponentially after that.  The only time in U.S. history that the debt-to-GDP ratio has been in the neighborhood of 100 percent was during World War II.  People at that time understood the situation to be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact they did.  In contrast, under the scenario I have been discussing, the debt-to-GDP ratio would rise far into the future at an accelerating rate.  Ultimately, this expansion of debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts or tax increases, or both. 

If current trends continue, the typical U.S. worker will be considerably more productive several decades from now.  Thus, one might argue that letting future generations bear the burden of population aging is appropriate, as they will likely be richer than we are even taking that burden into account.  On the other hand, I suspect that many people would agree that a fair outcome should involve the current generation shouldering at least some of that burden, especially in light of the sacrifices that previous generations made to give us the prosperity we enjoy today.

Globalization makes it harder to sustain a Social Security system based upon intergenerational transfers.  It exposes much more rapidly and acutely the inherent limits of such policies.  If our fiscal authorities were to take this and other real world verities into account, it might just encourage better policies.  And putting our fiscal house in order before our competitors do would further enhance our edge as an investment destination, securing the future of successive generations of Americans.

Coddling inflation by monetizing deficits is not an option in a globalized world.  It would erode our currency's value and undermine our economy's potential to grow and create jobs.  The solution to the problems laid out by the participants in today's conference rests squarely in the hands of our politicians, not with the central bank.

Fundamental to our economic strength has been the pro-growth policies the President has championed. Lower tax rates for all taxpayers put money back in the hands of consumers. An increase in expensing for capital investment gave a boost to small businesses. It's important to continue this growth that we make the tax cuts permanent.  It is also important that we exercise fiscal discipline. The increased spending required for hurricane recovery efforts make this all the more important. We are currently on the path to cut the federal deficit in half by 2009, and while economic growth has helped the growth of Treasury receipts quite a bit, spending restraint is the necessary other-half to the deficit-cutting process.

Social Security is on a financially unsustainable path. Reforming the system will address some critical long-term economic issues. It will help address the looming unfunded obligations which threaten the fiscal outlook. Another key to reform is stopping the practice of the government writing itself IOUs, while spending dollars intended for Social Security on unrelated programs. This has to stop.

Now, the inflation rate is near the upper end of the Fed’s tolerance zone, and it shows little inclination to go in the other direction. We now face higher energy prices and businesses’ desire to pass the increased costs on to their customers. Combine the energy spikes with spending increases by governments at every level in the aftermath of the two hurricanes...and you have new demand pressures added to the old ones.

While uncertainty surrounds Katrina’s effects on economic growth and core inflation, one thing is clear: Congress and the executive branch are acting swiftly to provide emergency funding for the affected areas. So far, the federal government has authorized more than $62 billion for recovery efforts. I have asked my staff to carefully monitor this spending. Obviously, the political authorities, not the Federal Reserve, have the power of the purse. I pray they act wisely. With the nation’s already large fiscal deficits, I personally believe it would be ill-advised for the Fed to monetize any fiscal profligacy.

As for the impact of the situation in the Gulf Coast on policy...In my view, the greatest contribution monetary policy can make is to keep the national economy on an even keel. Monetary policy, unfortunately, has little scope to cushion the immediate economic fallout from such a severe and sudden blow to a region...It is fiscal policy—government spending and transfers—that is necessary to address the immediate needs of the affected areas.

The Bush administration came into office intending to permanently reduce tax rates as a strategy for fostering stronger economic performance over the long term...Without a doubt, this application of counter-cyclical fiscal policy was extraordinarily well timed and effective.

The Board [of Governors] is aware of the current and growing regulatory burden that is imposed on this nation’s banking organizations. Often this burden falls particularly hard on small institutions...The Board strongly supports the efforts of Congress to review periodically the federal banking laws to determine whether they can be streamlined without compromising the safety and soundness of banking organizations, consumer protections, or other important objectives that Congress has established for the financial system.

Excessive fiscal spending tends to boost output in the short run but eventually adds risks to our economy and restricts the effectiveness of monetary policy. The fundamental issues of how to deal with Social Security and rising retiree health care costs only serve to complicate our challenges with fiscal policy.