Fiscal policy is needed

The central focus of the Bernanke speech at Jackson Hole was very clear. There are limits to what monetary policy can o. This does not mean that more action will not be taken but there are limits. Rates cannot come down any further so any change will have to be structural. That structural change could mean adjusting the shape of the yield curve. It could mean changing the rules of interest payments on excess reserves. These type of changes can help on the margin but there will not be a substitute for better fiscal policy.

Fiscal policy has to come in two forms which may seam contradictory. First, there is more nee for immediate stimulus. research suggests that fiscal policy is more important during times when rates are very low. The cost of crowding out is low. Second, there has to be changes in long-term deficits. Put another way, there needs to be cyclical stimulus and structural debt reduction at the same time.

The reaction of the markets has been strange with a strong rally on Friday. The Fed says nothing and the market rallies. We already knew that they would not be negative so why the rally? we will have to wait until next week to determine what the market is thinking.