Policy Rules can Help Mitigate Consumer and Business Uncertainty: Cleveland Fed Researcher

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Public officials need to think about how the actions they take today may play out in the future, says a researcher from the Federal Reserve Bank of Cleveland. Adding rules to new policies that would make altering them in the future difficult, would help to mitigate consumer and business uncertainty.

A good policy rule must allow for fiscal action in extraordinary circumstances. At the same time, it must force the current government to take into account the costs of today’s actions on future generations and maintain a long-run perspective.

The elections are over. As public officials renew their focus on policymaking, they need to be thinking about how the actions they take today may play out in the future, says Daniel Carroll, a researcher from the Federal Reserve Bank of Cleveland.

Government policy is typically designed to be in effect for long periods. But election turnover creates a disconnect – today’s government cannot commit that future governments will carry out its policies.

According to Carroll, if households and businesses cannot be certain that a policy will remain unchanged over its scheduled tenure, they will adjust their response to the policy to reflect this uncertainty. And the outcome policymakers intend to achieve may not be what actually occurs.

One way of mitigating the uncertainty, says Carroll, is to add rules to new policies that would make altering the policies in the future difficult.

Central banks, for example, are charged with maintaining long-term economic targets, such as low inflation. Granting central banks independence from the government allows their policy focus to extend beyond any election cycle and helps to assure that their policies will be maintained. Central bank independence thus helps to keep the public’s inflation expectations low and anchored.

On the fiscal side, a simple solution would be a financing rule, like an expenditure rule or a balanced budget amendment.

Carroll says that the key to making these types of rules work is to make violating the commitment very costly. He also says that penalties should be enforced from outside of the government, for example by the market.

“A good rule must allow for fiscal action in extraordinary circumstances, like the recent recession or a war,” he notes. “At the same time, it must force the current government to take into account the costs of today’s actions on future generations and maintain a long-run perspective.”

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Anne M. DiTeodoro
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