On 10 March, the House of Representatives gave final approval to President Biden’s $1.9tr fiscal stimulus plan (the American Rescue Plan). Worth over 9% of GDP, this represents the third stage of an unparalleled boost to the US economy. In March 2020, President Trump secured congressional agreement for a $2.2tr package (the CARES Act). Then in December 2020, a bipartisan COVID relief bill, worth $902bn, was passed by Congress.
By comparison, the Obama package in 2009 in response to the impending recession following the financial crisis was $831bn (5.7% of GDP).
The American Rescue Plan
The Biden stimulus programme consists of a range of measures, the majority of which provide monetary support to individuals. These include a payment of $1400 per person for single people earning less than $75 000 and couples less than $150 000. These come on top of payments of $1200 in March 2020 and $600 in late December. In addition, the top-up to unemployment benefits of $300 per week agreed in December will now continue until September. Also, annual child tax credit will rise from $2000 annually to as much as $3600 and this benefit will be available in advance.
Other measures include $350bn in grants for local governments depending on their levels of unemployment and other needs; $50bn to improve COVID testing centres and $20bn to develop a national vaccination campaign; $170bn to schools and universities to help them reopen after lockdown; and grants to small businesses and specific grants to hard-hit sectors, such as hospitality, airlines, airports and rail companies.
Despite supporting the two earlier packages, no Republican representative or senator backed this latest package, arguing that it was not sufficiently focused. As a result, reaction to the package has been very much along partisan lines. Nevertheless, it is supported by some 90% of Democrat voters and 50% of Republican voters.
Is the stimulus the right amount?
Although the latest package is worth $1.9tr, aggregate demand will not expand by this amount, which will limit the size of the multiplier effect. The reason is that the benefits multiplier is less than the government expenditure multiplier as some of the extra money people receive will be saved or used to reduce debts.
With $3tr representing some 9% of GDP, this should easily fill the estimated negative output gap of between 2% and 3%, especially when multiplier effects are included. Also, with savings having increased during the recession to put them some 7% above normal, the additional amount saved may be quite small, and wealthier Americans may begin to reduce their savings and spend a larger proportion of their income.
So the problem might be one of excessive stimulus, which in normal times could result in crowding out by driving up interest rates and dampening investment. However, the Fed is still engaged in a programme of quantitative easing. Between mid-March 2020 and the end of March 2021, the Fed’s portfolio of securities held outright grew from $3.9tr to $7.2tr. What is more, many economists predict that inflation is unlikely to rise other than very slightly. If this is so, it should allow the package to be financed easily. Debt should not rise to unsustainable levels.
Other economists argue, however, that inflationary expectations are rising, reflected in bond yields, and this could drive actual inflation and force the Fed into the awkward dilemma of either raising interest rates, which could have a significant dampening effect, or further increasing money supply, potentially leading to greater inflationary problems in the future.
A lot will depend what happens to potential GDP. Will it rise over the medium term so that additional spending can be accommodated? If the rise in spending encourages an increase in investment, this should increase potential GDP. This will depend on business confidence, which may be boosted by the package or may be dampened by worries about inflation.
Additional packages to come
Potential GDP should also be boosted by two further packages that Biden plans to put to Congress.
The first is a $2.2tr infrastructure investment plan, known as the American Jobs Plan. This is a 10-year plan to invest public money in transport infrastructure (such as rebuilding 20 000 miles of road and repairing bridges), public transport, electric vehicles, green housing, schools, water supply, green power generation, modernising the power grid, broadband, R&D in fields such as AI, social care, job training and manufacturing. This will be largely funded through tax increases, such as gradually raising corporation tax from 21% to 28% (it had been cut from 35% to 21% by President Trump) and taxing global profits of US multinationals. However, the spending will generally precede the increased revenues and thus will raise aggregate demand in the initial years. Only after 15 years are revenues expected to exceed costs.
The second is a yet-to-be announced plan to increase spending on childcare, healthcare and education. This should be worth at least $1tr. This will probably be funded by tax increases on income, capital gains and property, aimed largely at wealthy individuals. Again, it is hoped that this will boost potential GDP, in this case by increasing labour productivity.
With earlier packages, the total increase in public spending will be over $8tr. This is discretionary fiscal policy writ large.
- Biden’s $1.9 trillion COVID-19 bill wins final approval in House
Reuters, Susan Cornwell and Makini Brice (10/3/21)
- Biden’s Covid stimulus plan: It costs $1.9tn but what’s in it?
BBC News, Natalie Sherman (6/3/21)
- Biden’s $1.9 Trillion Challenge: End the Coronavirus Crisis Faster
New York Times, Jim Tankersley and Sheryl Gay Stolberg (22/3/21)
- Joe Biden writes a cheque for America – and the rest of the world
The Observer, Phillip Inman (13/3/21)
- Spend or save: Will Biden’s stimulus cheques boost the economy?
Aljazeera, Cinnamon Janzer (9/3/21)
- After Biden stimulus, US economic growth could rival China’s for the first time in decades
CNN, Matt Egan (12/3/21)
- Larry Summers, who called out inflation fears with Biden’s $1.9 trillion COVID-19 relief package, says the US is seeing ‘least responsible’ macroeconomic policy in 40 years
Business Insider, John L. Dorman (21/3/21)
- With $1.9 Trillion in New Spending, America Is Headed for Financial Fragility
Barron’s, Leslie Lipschitz and Josh Felman (30/3/21)
- Biden unveils ‘once-in-a generation’ $2tn infrastructure investment plan
The Guardian, Lauren Gambino (31/3/21)
- Biden unveils $2tn infrastructure plan and big corporate tax rise
Financial Times, James Politi (31/3/21)
- The Observer view on Joe Biden’s audacious spending plans
The Observer, editorial (11/4/21)
- Draw a Keynesian cross diagram to show the effect of an increase in benefits when the economy is operating below potential GDP.
- What determines the size of the benefits multiplier?
- Explain what is meant by the output gap. How might the pandemic and accompanying emergency health measures have affected the size of the output gap?
- How are expectations relevant to the effectiveness of the stimulus measures?
- What is likely to determine the proportion of the $1400 stimulus cheques that people spend?
- Distinguish between resource crowding out and financial crowding out. Is the fiscal stimulus package likely to result in either form of crowding out and, if so, what will determine by how much?
- What is the current monetary policy of the Fed? How is it likely to impact on the effectiveness of the fiscal stimulus?
Donald Trump has suggested that the Fed should cut interest rates by 1 percentage point and engage in a further round of quantitative easing. He wants to see monetary policy used to give a substantial boost to US economic growth at a time when inflation is below target. In a pair of tweets just before the meeting of the Fed to decide on interest rates, he said:
China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!
But would this be an appropriate policy? The first issue concerns the independence of the Fed.
It is supposed to take decisions removed from the political arena. This means sticking to its inflation target of 2 per cent over the medium term – the target it has officially had since January 2012. To do this, it adjusts the federal funds interest rate and the magnitude of any bond buying programme (quantitative easing) or bond selling programme (quantitative tightening).
The Fed is supposed to assess the evidence concerning the pressures on inflation (e.g. changes in aggregate demand) and what inflation is likely to be over the medium term in the absence of any changes in monetary policy. If the Federal Open Market Committee (FOMC) expects inflation to exceed 2 per cent over the medium term, it will probably raise the federal funds rate; if it expects inflation to be below the target it will probably lower the federal funds rate.
In the case of the economy being in recession, and thus probably considerably undershooting the target, it may also engage in quantitative easing (QE). If the economy is growing strongly, it may sell some of its portfolio of bonds and thus engage in quantitative tightening (QT).
Since December 2015 the Fed has been raising interest rates by 0.25 percentage points at a time in a series of steps, so that the federal funds rate stands at between 2.25% and 2.5% (see chart). And since October 2017, it has also been engaged in quantitative tightening. In recent months it has been selling up to $50 billion of assets per month from its holdings of around $4000 billion and so far has reduced them by around £500 billion. It has, however, announced that the programme of QT will end in the second half of 2019.
This does raise the question of whether the FOMC is succumbing to political pressure to cease QT and put interest rate rises on hold. If so, it is going against its remit to base its policy purely on evidence. The Fed, however, maintains that its caution reflects uncertainty about the global economy.
The second issue is whether Trump’s proposed policy is a wise one.
Caution about further rises in interest rates and further QT is very different from the strongly expansionary monetary policy that President Trump proposes. The economy is already growing at 3.2%, which is above the rate of growth in potential output, of around 1.8% to 2.0%. The output gap (the percentage amount that actual GDP exceeds potential GDP) is positive. The IMF forecasts that the gap will be 1.4% in 2019 and 1.3% in 2020 and 2021. This means that the economy is operating at above normal capacity working and this will eventually start to drive up inflation. Any further stimulus will exacerbate the problem of excess demand. And a large stimulus, as proposed by Donald Trump, will cause serious overheating in the medium term, even if it does stimulate growth in the short term.
For these reasons, the Fed resisted calls for a large cut in interest rates and a return to quantitative easing. Instead it chose to keep interest rates on hold at its meeting on 1 May 2019.
But if the Fed had done as Donald Trump would have liked, the economy would probably be growing very strongly at the time of the next US election in November next year. It would be a good example of the start of a political business cycle – something that is rarer nowadays with the independence of central banks.
- What are the arguments for central bank independence?
- Are there any arguments against central bank independence?
- Explain what is meant by an ‘output gap’? Why is it important to be clear on what is meant by ‘potential output’?
- Would there be any supply-side effects of a strong monetary stimulus to the US economy at the current time? If so, what are they?
- Explain what is meant by the ‘political business’ cycle? Are governments in the UK, USA or the eurozone using macroeconomic policy to take advantage of the electoral cycle?
- The Fed seems to be ending its programme of quantitative tightening (QT). Why might that be so and is it a good idea?
- If inflation is caused by cost-push pressures, should central banks stick rigidly to inflation targets? Explain.
- How are expectations likely to affect the success of a monetary stimulus?
The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.
But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.
This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.
As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”
A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.
The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.
Fed’s asset shift to pose new test of economy’s recovery, resilience Reuters, Howard Schneider and Richard Leong (6/4/17)
Federal Reserve likely to begin cutting back $4.5 trillion balance sheet this year Washington Post, Ana Swanson (5/4/17)
Why the Fed’s debate about shrinking its balance sheet really, really matters Money Observer, Russ Mould (7/4/17)
The Fed and ECB keep a cautious eye on the exit Financial Times (7/4/17)
Get ready for the Fed’s next scary policy change CBS Money Watch, Anthony Mirhaydari (5/4/17)
The Fed wants to start shrinking its $4.5 trillion balance sheet later this year Business Insider, Akin Oyedele (5/4/17)
Inside the Fed’s March Meeting: The Annotated Minutes Bloomberg, Luke Kawa, Matthew Boesler and Alex Harris (5/4/17)
QE was great for asset prices – will ‘QT’ smash them? The Financial Review (Australia), Patrick Commins (7/4/17)
Shrinking the Fed’s balance sheet Brookings, Ben Bernanke (26/1/17)
Selected data Board of Governors of the Federal Reserve System
- Distinguish between active and passive QT.
- If QE is a form of expansionary monetary policy, is QT a form of contractionary monetary policy?
- Could QT take place alongside an expansion of broad money?
- What dangers lie in the Fed scaling back its holdings of government (Treasury) bonds and mortgage-backed securities?
- Why is it unlikely that the Fed will reduce its holdings of securities to pre-crisis levels?
- Why are the Bank of England, the ECB and the Bank of Japan still pursuing a policy of QE?
- What are the implications for exchange rates of QT in the USA and QE elsewhere?
- Find out data for the monetary base, for narrow money (M1) and broader money (M2) in the USA. Are narrow and/or broad money correlated with Federal Reserve asset holdings?
On 14 December, the US Federal Reserve announced that its 10-person Federal Open Market Committee (FOMC) had unanimously decided to raise the Fed’s benchmark interest rate by 25 basis points to a range of between 0.5% and 0.75%. This is the first rise since this time last year, which was the first rise for nearly 10 years.
The reasons for the rise are two-fold. The first is that the US economy continues to grow quite strongly, with unemployment edging downwards and confidence edging upwards. Although the rate of inflation is currently still below the 2% target, the FOMC expects inflation to rise to the target by 2018, even with the rate rise. As the Fed’s press release states:
Inflation is expected to rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.
The second reason for the rate rise is the possible fiscal policy stance of the new Trump administration. If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
However, just how much and when the Fed will raise interest rates again is highly uncertain. Future monetary policy measures will only become more predictable when Trump’s policies and their likely effects become clearer.
US Federal Reserve raises interest rates and flags quicker pace of tightening in 2017 Independent, Ben Chu (14/12/16)
US Federal Reserve raises interest rates: what happens next? The Telegraph, Szu Ping Chan (15/12/16)
Holiday traditions: The Fed finally manages to lift rates in 2016 The Economist (14/12/16)
US raises key interest rate by 0.25% on strengthening economy BBC News (14/12/16)
Fed Raises Key Interest Rate, Citing Strengthening Economy The New York Times, Binyamin Appelbaum (14/12/16)
US dollar surges to 14-year high as Fed hints at three rate hikes in 2017 The Guardian, Martin Farrer and agencies (15/12/16)
- What determines the stance of US monetary policy?
- How does fiscal policy impact on market interest rates and monetary policy?
- What effect does a rise in interest rates have on exchange rates and the various parts of the balance of payments?
- What effect is a rise in US interest rates likely to have on other countries?
- What is meant by ‘forward guidance’ in the context of monetary policy? What are the benefits of providing forward guidance?
- What were the likely effects on the US stock market of the announcement by the FOMC?
- Following the FOMC announcement, two-year US Treasury bond yields rose to 1.231%, the highest since August 2009. Explain why.
- For what reason does the FOMC believe that the US economy is already expanding at roughly the maximum sustainable pace?
As we saw in the news item The difficult exit from cheap money, central banks around the world have been operating an extremely loose monetary policy since the beginning of 2009. Their interest rates have been close to zero and trillions of dollars of extra money has been injected into the world economy through various programmes of quantitative easing.
For the past few months the Federal Reserve has been purchasing bonds under its most recent programme dubbed QE3, and thereby increasing narrow money, by $85 billion per month. Since the start of its QE programme in 2009, it has pumped around $2.8 trillion of extra money into the US and world economies. This huge increase in money supply has boosted the demand for assets worldwide and world stock markets have risen. Much of the money has flowed into developing countries, such as India, and has acted as a boost to their economies.
Once the US economy is growing strongly again, the aim is to taper off, and ultimately end or even reverse, the QE programme. It was expected that the Fed would decide to start this tapering off process at its meeting on 18 September – perhaps reducing bond purchases initially by some $10 billion. (Note that this would still be an increase in money supply, just a slightly smaller one.) Over the past few days, US bond prices have been falling (and yields increasing) in anticipation of such a move.
As it turned out, the Fed decided to delay tapering off. It will continue with its assets purchase programme of $85 billion per month for the time being. The reason given was that the US economy was still too fragile and needed the monthly injections of money to stay at the current level.
Normally it might be expected that the announcement of a more fragile recovery would cause the US stock market, and others worldwide, to fall. In fact the opposite occurred, with investors relieved that the extra money, which allows extra asset purchases, would continue at the same rate.
But this then raises the question of just what will be the effect when tapering off does actually occur. Will stock markets then go into a tailspin? Or will they merely stop rising so fast. That depends very much on the role of speculation.
Bernanke’s Own Words on Asset Purchases, Economy Bloomberg (18/9/13)
Bernanke: Fed to delay bond tapering PBS Newshour on YouTube (full speech plus questions) (18/9/13)
No tapering announced by Fed CNBC on Yahoo Finance (18/9/113)
The impact of US stimulus moves at home and abroad BBC News, Stephanie Flanders (18/9/13)
Is the upturn reaching Americans? BBC World, Stephanie Flanders (17/9/13)
Shares hit high as Federal Reserve maintains stimulus BBC News, Stephanie Flanders (18/9/13)
US Fed decision to delay tapering was a relief ET Now (India), Bimal Jalan (19/9/13)
Federal Reserve surprises markets by delaying QE tapering The Telegraph, Katherine Rushton (18/9/13)
Federal Reserve delays QE tapering: the full statement The Telegraph (18/9/13)
Q&A: What is tapering? BBC News (18/9/13)
Fed delay is no reason to celebrate The Guardian, Larry Elliott (19/9/13)
Federal Reserve tapering decision has baffled the markets The Guardian, Larry Elliott (19/9/13)
Taper tiger The Economist (21/9/13)
Everything You Need to Know About the Fed’s Decision Not to Taper QE3 The Atlantic, Matthew O’Brien (18/9/13)
Fed’s dovish turn leaves Wall Street economists mulling taper timing: poll Reuters, Chris Reese (18/9/13)
Good news and bad news from the Fed BBC News, Stephanie Flanders (19/9/13)
Is the Fed frightened of its shadow? BBC News, Robert Peston (19/9/13)
The Federal Reserve and Janet Yellen face a tough task with insufficient tools The Guardian, Mohamed A. El-Erian (14/10/13)
- Why might a slowing down in the increase in US money supply cause asset prices to fall, rather than merely to rise less quickly?
- Why has the US QE programme led to a rise in asset prices overseas?
- Distinguish between stabilising and destabilising speculation. Which type of speculation has been occurring as a result of the US QE programme?
- How has QE affected unemployment in the UK and USA? How is the participation rate and the flexibility of labour markets relevant to the answer?
- Explain the following two statements by Stephanie Flanders and Robert Peston respectively. “The market conditions argument has a circularity to it: talk of tapering leads to higher market rates, which in turn puts the taper itself on hold.” “The Fed simply hinting that less money would be created, means that there will be no reduction in the amount of money created (for now at least).”
- Why have US long-term interest rates, including mortgage rates, risen since May of this year?
- What impact have higher US long-term interest rates had on economies in the developing world? Explain.