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Wednesday, October 12, 2005

Fed Governor Olson on the Fiscal Outlook for the U.S. Economy

Continuing the roundup of recent remarks by Fed officials here, here, and here, Fed Governor Olson discusses his concern about the fiscal outlook for the U.S. economy, and the outlook for monetary policy and the economy.

As the sole dissenting vote at the last FOMC meeting, governor Olson established his willingness to take an independent position and he explains why he dissented as part of his remarks. In his speech, he hints about future monetary policy more than the other Fed officials did in their speeches. He is not particularly worried about the output effects of the hurricane, but he is keeping a watchful eye on prices to see how much of the increase in the price of energy inputs passes through to output prices. More notably, he is worried about the long-term fiscal outlook for the U.S. He believes budget rules need to be implemented to solve the ongoing deficit problem and moderate the tendency of congress to deficit spend:

Update on the U.S. Economy and Fiscal Outlook, by Fed Governor Mark W. Olson: ...My remarks will focus on the near-term economic outlook of the United States in the immediate post-hurricane aftermath. Then I will address the fiscal challenges that the country confronts... I had expected that I would be going into the September FOMC meeting, and then speaking to you, with the U.S. economy on an upward trajectory. But that expectation changed dramatically when Hurricanes Katrina and Rita came along. Although the combined effect of the hurricanes was contained within a geographic area ..., the potential for spillover effects on the economy more broadly was difficult to assess. The disruptive effect on oil refining, natural gas distribution, and chemical production; the damage to major ports and transportation infrastructure; and the significant devastation of a major city raised the risks of an effect on the economy that exceeded the direct effects on the areas battered by the storms. To be sure, these disruptions also had adverse implications for costs and prices. Further clouding the picture, the fiscal policy implications of funding the rebuilding and restoration had not yet been fully defined.

As our September FOMC meeting followed Hurricane Katrina by approximately three weeks and was held concurrently with the formation of Hurricane Rita, I felt that there was insufficient information as well as great uncertainty about how these forces would play out in the near term. As a result, I voted to pause in the removal of policy accommodation until more was known. ... A frustrating aspect of the situation is that even now, some six weeks after the first of the hurricanes made landfall, the incoming data are only beginning to shed some light on the economic ramifications of the storms. Clearly, however, the destructive power of these hurricanes reduced economic activity ... The Federal Reserve estimates that Hurricane Katrina reduced industrial production by 0.3 percent in August, even though it struck near the end of the month. Oil and gas production and refining were particularly hard hit. ... Petroleum refining, chemical plants, and electricity distribution were also relatively hard hit by the hurricanes. All told, industrial production was held down significantly in September as a result of lower output in these sectors. That said, various daily and weekly data sources indicate that the industrial sector is beginning to recover in October ... Industry sources suggest that much of the repair and recovery effort will likely be undertaken over the course of the next several months, and as that occurs, production rates should gradually return to normal. Beyond the industrial sector, one indicator of economic activity more broadly is the behavior of employment. Last week's employment report for September indicated ... the direct disruption effects of the hurricane. More important, the apparent absence of significant indirect effects in other areas of the United States is an indication that the underlying gains in employment and income were well maintained outside the Gulf region.

An important question for policymakers is how inflation and economic activity will respond in coming months. One concern is that the rise in energy prices, as well as the downshift in consumer confidence seen in recent readings, may hold back aggregate demand at least for a time. However, the rebuilding itself should provide some impetus to demand in coming quarters. At the same time, of course, higher prices for energy items, including gasoline, heating oil, and natural gas, will be adding to top-line inflation in the near term. As well, these price increases will put upward pressure on the costs of the producers of other items, thereby posing the risk of some impetus to core inflation. Whether these pressures are, in fact, passed through to core inflation will depend on a host of considerations, ... Needless to say, developments in this area will be the subject of intense scrutiny on my part in coming months.

A vital contributor to the rebuilding and recovery effort will be the various actions of the federal government. The magnitude of the devastation called for a significant response from the federal government, and the Congress and the President acted quickly to provide emergency spending and tax breaks to aid the areas affected by the hurricanes. Whether these emergency fiscal measures will ultimately be financed by increased federal borrowing, or by finding offsetting spending decreases or revenue increases, is still an unsettled issue in the Congress. To a certain extent, temporary emergency federal borrowing may be viewed as appropriate, as the costs would ultimately be spread out across all U.S. taxpayers over time. Nonetheless, given the current size of the federal deficit, additional federal borrowing raises issues because of the potential negative effects that higher deficits can have on the economy. ... the budget figures for the fiscal year just ended were little affected by the fiscal policy response to the recent hurricanes. Only a small portion of the emergency federal outlays budgeted for hurricane relief were actually spent in September, ... Moreover, the total magnitude of the federal response is still unknown, adding to the uncertainty associated with the fiscal outlook.

Viewed from a longer-term perspective, the financial position of the U.S. federal budget has oscillated dramatically over the past ten years. Ten years ago, the federal budget had a deficit that amounted to about 2-1/2 percent of GDP, ... the best estimates ten years ago had the federal budget still running deficits far into the future. However, as it turned out, a number of positive developments pushed the budget into surplus in 1998 through 2001. Importantly, bipartisan support in the Congress for establishing and maintaining some measure of budget discipline was demonstrated by adherence to the guidelines set by the PAYGO rule and the discretionary spending caps. ... The federal budget also benefited significantly from economic developments that occurred outside of policy actions. In particular, federal tax revenues increased substantially more rapidly than expected and at a rate greater than the robust pace of economic growth seen in the late 1990s. Also, the rate of growth of medical care costs slowed somewhat from its high previous rate, in part because of legislative changes. Remarkable as it now seems, progress on the deficit was sufficiently dramatic that only five years ago serious policy discussions were undertaken concerning the possibility of effectively retiring all outstanding U.S. federal government debt. Obviously, the federal budget did not continue to unfold in the manner projected at that time.

The rapid pace of ascent from deficit to surplus in the late 1990s was exceeded by the pace of descent back to deficits beginning in 2002. This development was the result of a number of factors. In 2001, tax cuts approximately the size of projected on-budget surpluses were passed. Defense and homeland security spending increased in the wake of the attacks on September 11, 2001, and other nondefense domestic spending also increased at a substantially faster rate. The budget rules put in place back in 1990 ... both the caps on discretionary spending and the PAYGO rule--were allowed to expire after 2002 ... Besides these policy actions, spending for federal health programs also increased at faster rates as a result of a reacceleration in medical costs. During this time, the economy experienced a mild recession, and the stock market declined for several years after its peak in 2000...

Worrisome as these short-term fiscal issues are for the United States, they pale in comparison with the fiscal issues that are projected to begin emerging by the end of this decade. ... pressure on the U.S. federal government budget, as spending for federal government retirement and health programs will rise rapidly. A more slowly growing workforce could also tend to damp economic growth and, thus, federal tax revenues. So far, solutions to these long-term challenges have eluded policymakers. It is imperative, however, that solutions be identified and implemented. The sooner such changes are made, the less painful and disruptive they will be. ... The most important factor in ultimately achieving a federal government budget that balances over the business cycle and maintains that fiscal discipline over time is the will of the political system to make the necessary hard choices on government spending and taxes. ... Clearly, there are numerous ways in which budget policy could be adjusted to bring the budget back into balance in the short run and to maintain it over the long run. In any event, these difficult choices must ultimately be made.

If left unchecked, persistent and widening federal government deficits will have an increasingly corrosive effect on the U.S. economy because, all else being equal, federal government borrowing takes up some of the funds that would otherwise go to finance capital accumulation or to purchase capital assets from abroad. A good deal of controversy has swirled around the question of whether increased federal borrowing reduces domestic investment, and presumably increases interest rates, or whether it increases U.S. borrowing from abroad. Viewed from a broader perspective, however, that distinction is probably not very consequential because future national income is lower in either case. For the federal government to run a deficit in the short run as a temporary response to an emergency event, such as the recent devastating hurricanes, or a recession or a war is not the type of fiscal policy imbalance that tends to have a negative long-run effect on an economy. To the contrary, appropriate discretionary fiscal responses to these types of situations can have beneficial economic effects ... However, it is imperative that the nation come to grips with the ... federal government spending programs and taxes to bring the budget toward balance ... The benefits of taking timely and appropriate federal budget actions are important for the long-run health of the U.S. economy.

    Posted by on Wednesday, October 12, 2005 at 01:40 PM in Budget Deficit, Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (1)


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