Federal Reserve Chairman Ben Bernanke said if the country falls off the fiscal cliff, the economy will be damaged in way the Fed can’t control.
“I don’t think Federal Reserve has tools to offset the effect…we’d have to temper the expectations of what we can accomplish.” said Mr. Bernanke, who coined the phrase fiscal cliff for the looming tax hikes and government spending cuts set to begin in 2013.
Mr. Bernanke said that while the Fed could increase asset purchases “a bit,” it can’t offset fully the effects through added stimulus.
There are indeed reasons to fear falling off the cliff. Scheduled increases in taxes on capital formation, for example, would do long-term damage to the economy. The Keynesian nightmare about the cliff is overwrought, however, because the Federal Reserve has the power to avert it. For that matter, Congress could cut spending much more deeply than it is now considering without risking a recession — at least if the Fed acts appropriately.
The point should be easy to grasp if you imagine a central bank that has a 2 percent inflation target that it hits every year. Under those circumstances, neither fiscal stimulus nor austerity can change levels of inflation or output. If a stimulus inflated the economy, the central bank would just deflate it again to hit its target. If austerity shrank the economy, the central bank would re-inflate it. The total amount of economic activity would not change (although how much of it was directed by private-sector actors would).
The same conclusion — that changes in the federal budget position cannot affect the size of the economy overall — follows if the central bank substitutes a nominal-spending target for an inflation target and hits it every year. In the real world, of course, central banks do not hit their targets perfectly. They do, however, have the power to come close, which means that fiscal policy cannot have a large effect if they are trying.