The automatic spending cuts that begin Friday might not have much of an impact on the Federal Reserve Board’s current policy course. But they will add a layer of complexity to the Fed's deepening debate over whether to start tapering its massive bond-buying program aimed at lifting the economy.
In September, the Fed launched the program, known as QE3, to combat weakness in the job market. Under QE3, the central bank has pledged to buy $85 billion each month in Treasury bonds and mortgage-backed securities until the labor market improves “substantially.”
In recent weeks, a debate has intensified over when—and how—the Fed will pull back from those asset purchases and raise its benchmark interest rate, which it has kept near zero for over four years. The minutes from the Fed's latest policy-setting meeting revealed that some officials are growing worried enough about the risks of continuing the bond purchases that they want to consider exiting the program sooner than initially planned.
Fed Chairman Ben Bernanke made clear in two days of congressional testimony this week that he still believes the stimulative benefits of the policies outweigh the dangers, even as he acknowledged some risks. “In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery,” he said.
The automatic cuts--known as the sequester in Washington parlance--complicate the calculus. The sequester, mandated under the 2011 Budget Control Act, was put in place to push Congress and the White House to reach a compromise on long-term budget reduction. But no agreement is in sight, and now Washington is bracing for $85 billion in cuts this year that economists say will put a damper on economic growth. The Congressional Budget Office has estimated that the sequester will knock 0.6 percentage points off of gross domestic product in 2013. CBO estimates that 750,000 fewer jobs will be created this year than would otherwise be the case.
This is where it gets tricky for the Fed: A weaker economy and jobs market argue for more accommodative monetary policy. “If all of the spending cuts that are mandated by the sequester go fully into effect and remain in effect, you know, for the rest of this fiscal year, it’s going to have a notable effect on the economy,” said Lewis Alexander, U.S. chief economist at Nomura Global Economics. “And I think that would be enough to affect the timing of the Fed’s exit from its current asset-purchase program.”
But the threat of slower growth arrives just as the Fed wrestles with concerns—both inside and outside the central bank—over whether the easy-money policies are setting the stage for another crisis. Some also say the bank is now “pushing on a string” with actions that are providing only minimal help to the economy while posing dangers for the future.
Republican lawmakers urged Bernanke this week to remove some of the stimulus the Fed is already applying to the economy. “We have gone too far in the monetary policy and the monetary easing, and it is, in this member's opinion, time to pull back,” said Rep. John Campbell, R-Calif., citing the potential formation of an asset bubble among the risks of continued bond buying. A concern is that low yields will drive investors to risky behavior that could undermine the stability of the financial system.
Esther George, a member of the bank's policy-setting committee, expressed concern that the easing policies would increase the risk of “economic and financial imbalances” and voted against continuing QE3 in the January policy meeting. The minutes from the same meeting revealed that more than one member of the committee shared concerns that such risks could outweigh the program’s benefits sooner rather than later. “A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred,” they said.
A slowdown in the economy, though, would make it harder for the Fed to consider backing off the stimulus. Indeed, at the January Fed meeting, some officials argued that prematurely ending easy-money policies could harm growth at a time when the recovery is weighed down by a fiscal drag.
Here's another wrinkle: Not everyone thinks all of the spending cuts will stay in effect. Congress's next opportunity to hash out the country's fiscal future will come later this month, when a measure to fund the government's operations expires. Lawmakers will have to pass a continuing resolution to avoid a government shutdown. “If we do a deal sometime before March 27 that addresses not only the continuing resolution—you know, the need for an extension of the continuing resolution—but also adjusts these current levels of spending, the fact that we will have lived for a couple of weeks, you know, notionally under these spending cuts, won’t have much effect,” Alexander said.
In the end, the sequester is the latest example of how fiscal policy puts the Fed in an awkward place. Its officials are regularly called before Congress to answer for the country’s lackluster economy. But the politically independent institution refuses to throw its support behind specific fiscal policies, even when they might work in conflict with the central bank's monetary policy.