by Calculated Risk on 5/23/2009 07:30:00 PM

From Federal Reserve Vice Chairman Donald Kohn: Interactions between Monetary and Fiscal Policy in the Current Situation

A few excerpts:

[I]n the current weak economic environment, a fiscal expansion may be much more effective in providing a sustained boost to economic activity. With traditional monetary policy currently constrained from further reductions in the target policy rate, and with many analysts forecasting lower-than-desired inflation and a persistent, large output gap, agents may anticipate that the target federal funds rate will remain near zero for an extended period. In this situation, fiscal stimulus could lead to a considerably smaller increase in long-term interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset prices, than under more normal circumstances. Indeed, if market participants anticipate the expansionary fiscal policy to be relatively temporary, and the period of weak economic activity and constrained traditional monetary policy to be relatively extended, they may not expect any increase in short-term interest rates for quite some time, thus damping any rise in long-term interest rates.
emphasis added

And on the transition back to normal monetary policy:

An important issue with our nontraditional policies is the transition back to a more normal stance and operations of monetary policy as financial conditions improve and economic activity picks up enough to increase resource utilization. These actions will be critical to ensuring price stability as the real economy returns to normal. The decision about the timing of a turnaround in policy will be similar to that faced by the Federal Open Market Committee (FOMC) in every cyclical downturn--it has to choose when, and how quickly, to start raising the federal funds rate. In the current circumstances, the difference will be that we will have to start this process with an unusually large and more extended balance sheet.

In my view, the economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households. As a consequence, it probably will be some time before the FOMC will need to begin to raise its target for the federal funds rate. Nonetheless, to ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures.

Our expanded liquidity facilities have been explicitly designed to wind down as conditions in financial markets return to normal, because the costs of using these facilities are set higher than would typically prevail in private markets during more usual times.

Kohn argues:

Economy "only now beginning" to stabilize.

Kohn thinks the recovery will "be gradual amid the balance sheet repair of financial intermediaries and households".

Fed Funds rate will probably be zero for "some time".

The large output gap will keep long term interest rates and inflation in check.