(By Mani) A tighter fiscal policy may help Fed to exit the securities purchases. Tight fiscal policy could offset easy monetary policy until the Fed's portfolio begins to shed enough assets to tighten policy, an event that may take until 2018.
During the Clinton administration, tighter fiscal policy was thought to have allowed the Fed under Chairman Greenspan to maintain easier monetary policy than would otherwise have been the case.
This assumes significance when the President Barack Obama and Republicans are negotiating "fiscal cliff," which is nothing, but a budget and tax deal to avoid tax increases and automatic spending cuts.
"According to models, a $200 billion reduction in government spending is roughly the equivalent of between a 100bp to 200bp increase in the Fed funds rate, a drag consistent with a gradual rate hike cycle of 25bps per meeting," UBS economist Maury Harris said in a client note.
In contrast, a $200 billion increase in taxes would only create a net drag on growth equivalent to a 62.5 basis points (bps) increase in the Fed funds rate. To obtain a similar impact on growth to that of reducing government spending, they would need to increase taxes by between $400 billion and $500 billion. However, timing is important.
"The current fiscal cliff represents a danger due to both the speed and magnitude of the tightening, which would generate a drag equivalent to Fed tightening of over 200bps," Harris noted.
On the other hand, longer-term proposals, such as the President's recently announced plan are preferable as they are less abrupt. The long-term effects of the proposed $1.6 trillion, 10-year tax increase would create between 90 and 120 basis points of equivalent Fed tightening each year, excluding any interest rate lowering effects from deficit reduction.
"Tighter policy today would not be welcome as the current amount of stimulus in the economy seems sufficient only to allow growth of just over 2%, which would suggest allowing the fiscal cliff to hit now is folly," the economist said.
However, as growth accelerates in 2013 and 2014, it would appear to make sense to put a tighter fiscal policy into place, not just for the positive impact on the deficit, but also because such an action may be the only way for the Fed to extract itself from its quantitative easing programs – a feat that would make the Federal Reserve the only central bank to exit a QE program successfully.
In September, the Federal Reserve started the third round of Quantitative Easing measures (QE3) by announcing an open-ended $40 billion per month mortgage-backed securities (MBS) bond-buying program while maintaining Operation Twist and the reinvestment of pay-downs into agency MBS.
It also extended its interest rate guidance from late 2014 to mid-2015. For the remainder of the year, these combined actions will increase the Fed's holdings of long-term securities by roughly $85 billion per month.
At the December 11-12 FOMC meeting, the Fed is expected to announce its intention to continue buying long-dated US Treasury securities at the same pace seen during the "Twist" program.
If this new program and the recently announced mortgage-backed securities buying program are continued throughout 2013, it would take the Fed's balance sheet to roughly $4 trillion. This is $2.7 trillion over a "normal" balance sheet of $1.3 trillion.