By Narayana Kocherlakota
Editor’s note: Narayana Kocherlakota is the Lionel W. McKenzie professor of economics at the University of Rochester. He served as president of the Federal Reserve Bank of Minneapolis from 2009 through 2015. This column does not necessarily reflect the opinion of Capitol Report or of Bloomberg LP and its owners.
Donald Trump’s ideas about managing the U.S. government’s finances have generated a lot of debate, shedding useful light on the presidential hopeful’s unconventional approach to economic policy. But Trump has yet to address a crucial issue: How would he manage a likely conflict with one of the world’s most powerful institutions — the Federal Reserve?
Trump has proposed large spending increases and steep tax cuts, a combination that the nonpartisan Committee for a Responsible Federal Budget has estimated would boost government debt to 129 percent of gross domestic product over 10 years, from about 75 percent now. (As far as I can tell, this estimate does not include Trump’s more recent proposals to increase infrastructure and military spending.)
Fears that Trump’s policies would trigger a sovereign debt crisis have prompted him to offer largely unworkable plans to renegotiate the U.S. debt. There’s actually little reason, however, to believe that such a crisis would occur. As I have noted, a debt burden of 129 percent of GDP is not necessarily any less affordable than 75 percent. What matters is the trajectory of the budget deficit, which the U.S. must get under control over the next half century by either raising taxes or cutting benefits to older residents. The U.S. need not begin that process immediately — and more spending now might actually make it easier by increasing the economy’s longer-term growth potential.
Moreover, the world seems to need a lot more safe assets, such as the Treasury bonds that the U.S. issues to finance deficit spending. Trump’s fiscal plans would help meet this demand.
Problem is, Trump’s proposals are likely to run into direct conflict with the Fed’s monetary policy. More government spending and lower taxes would generate more demand for goods and services. This would add to inflationary pressures, raising the question: How would the Fed respond?
Right now, the Fed is sending conflicting signals. On one hand, it wants interest rates to rise only gradually — a passive approach that, combined with Trump’s proposals, would generate more employment and inflation. The risk is that inflation would exceed the Fed’s stated objectives, creating expectations of higher inflation that would require economically painful measures to extinguish.
On the other hand, given that the Fed has already been removing stimulus in the absence of inflationary pressures, it’s reasonable to expect that the central bank would tighten policy much faster if inflation actually appeared. Such an active approach would choke off private-sector demand, blunting the potential positive impact of Trump’s fiscal policy.
In this latter scenario, the Fed would be deliberately using monetary policy to counteract the president’s objectives. How would Trump handle such a conflict? The repercussions for the Fed, and for the conduct of monetary policy globally, could be far-reaching. It would be useful to hear from the candidate — and his supporters — on this key question.