Jeff Cox is puzzled – maybe because he never asked anybody about monetary policy

This is CNBC’s Jeff Cox:

Investors who fled in fear over potentially massive tax increases associated with the “fiscal cliff” have barely broken a sweat over corresponding spending cuts that are only two weeks away.

The so-called sequestration of $110 billion a year in discretionary spending will happen March 1 if Congress does not come to an agreement.

With little indication that Washington is anywhere near a compromise similar to the one that avoided the full brunt of the fiscal cliff, markets could be expected to be in full panic mode.

But the post-cliff rally has shown no signs of letting up and the topic has gained little traction around Wall Street.

It is clear that Jeff never read any Market Monetarist blogs. If he had he would have known that monetary policy always overrules fiscal policy – there is monetary policy dominance and therefore financial markets should not be worried about a sizable fiscal tightening.

With the Bernanke-Evans rule the Fed has committed itself to continuing and escalating – if necessary – monetary easing until there is a substantial improvement of US labour market conditions – essentially this is a commitment to increasing aggregate demand. Hence, the Fed is also committed to counteract any negative impact on aggregate demand from a potential tightening of fiscal policy.

I have explained earlier that there is no reason to fear the fiscal cliff as long as there is a ‘monetary backstop’ in the form of the Bernanke-Evans rule:

Even if the fiscal cliff would be a negative shock to private consumption and public spending it is certainly not given that that would lead to a drop in overall aggregate demand. As I have discussed in earlier posts if the central bank targets NGDP or inflation for that matter then the central bank tries to counteract any negative demand shock (for example a fiscal tightening) by a similarly sized monetary expansion.

Even if we assume that we are in a textbook style IS/LM world with sticky prices and where the money demand is interest rate sensitive the budget multiplier will be zero if the central bank follows a rule to stabilize aggregate demand/NGDP.

As I have shown in an earlier post the LM curve becomes vertical if the monetary policy rule targets a certain level of unemployment or aggregate demand. This is exactly what the Bernanke-Evans rule implies. Effectively that means that if the fiscal cliff were to push up unemployment then the Fed would simply step up quantitative easing to force back down unemployment again.

Obviously the Fed’s actual conduct of monetary policy is much less “automatic” and rule-following than I here imply, but it is pretty certain that a 3, 4 or 5% of GDP tightening of fiscal policy in the US would trigger a very strong counter-reaction from the Federal Reserve and I strongly believe that the Fed would be able to counteract any negative shock to aggregate demand by easing monetary policy. This of course is the so-called Sumner Critique.

So Jeff the reason the markets are so relaxed about the so-called sequestration might very well be that the Fed has regained some credibility that it actually is controlling aggregate demand/NGDP. I know it is hard to understand that it is not important what is going on in the US Congress, but the markets really don’t care as long as the Fed is doing its job.

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