Have the Federal Reserve work to offset every dollar drop in federal spending with a dollar increase in private sector spending. The Fed would incentivize the private sector to do this by raising expected future nominal income growth via aggressive open market operations or by helicopter drops. Rapidly raising the public's expectations of future nominal income growth would cause household and firms to increase current spending and offset the decline in federal spending. Aggressive open market operations could look like this and helicopters drops like this. The point is, the Fed is capable of keeping total current dollar spending stable if really wanted to do so. In fact, this stabilizing of nominal spending by the Fed has a name: nominal GDP level targeting. With a credible version of this target, the Fiscal Cliff should not be a big a deal. The only question is whether the Fed will act.
Along these lines, Michael Darda of MKM Partners had this to say:
Come on Fed, you can do this. Save us from the Fiscal Cliff.NGDP growth has been quite steady at about 4% per annum despite a 200-300bps swing in the fiscal deficit over the last several years and, over the last five quarters, the weakest real government spending growth since the Eisenhower era. The steadiness of NGDP since 2010 suggests that the Sumner critique is still operative, even at the zero lower bound on short rates. The Sumner critique states that fiscal multipliers converge toward zero if a central bank is NGDP or inflation. In other words, the central bank shifts policy in a way that offsets the effect of spending/tax changes on aggregate demand, or MV. Although the Fed does not currently target a path for NGDP, it is aiming for its dual-mandate contingency based on its forecast of how NGDP growth will evolve: While the Fed cannot currently cut rates to offset a shock, it can ramp up QE (or commit to making some portion of the monetary base permanent) to increase the money supply or to check a decline in velocity. Perhaps this also a reason to not worry too much about demand-side implications of the so-called “fiscal cliff” (assuming Bernanke will do enough QE to offset any potential drag on MV from the cliff).
P.S. Yes, I know a helicopter drop is really fiscal policy, but it probably needs to be initiated by Fed operation to make it politically viable.