The Short-Term Consequences of Deficit Reduction Under Different Economic Conditions

March 29, 2013

As I mentioned in an earlier blog post, we think that some of our answers to follow-up questions from Congressional hearings may be of general interest, so we’re posting them.

Following a recent hearing, we were asked by a Member of Congress: “Are there economic conditions under which deficit reduction would have a smaller effect on unemployment and GDP than under current conditions?” Here was our answer:

Deficit reduction would tend to have a smaller negative impact on GDP in the short run when the economy was stronger and monetary policy was less constrained in its ability to confront economic headwinds. Ordinarily, the Federal Reserve can seek to offset a tightening of fiscal policy by lowering short-term interest rates. But in the current economic environment, with output so far below its potential (maximum sustainable) level, the Federal Reserve has kept short-term interest rates near zero. As a result, the Federal Reserve would be unable to further reduce short-term interest rates to offset the negative short-run effects on GDP of tax increases or spending cuts. CBO currently projects that after output moves closer to its potential, the Federal Reserve will begin to raise short-term interest rates above zero in 2016. As we near that time, CBO expects that fiscal tightening would have a smaller effect on unemployment and GDP than it would have this year or next year.