FED interest rates, Inflation and the Zero-Boundary
The durability of our economic crisis was made possible by decades of low inflation, with correspondingly lower and lower average Fed interest rates. As Fed rates get nearer to zero there is less room to cut them and cutting rates is, by far, the Fed's greatest stimulative power. (Demonstrated and confirmed many times.)
A good analogy is an airplane engine stalling. If you find out the engine is stalled the first thing you want to know is your altitude. Stalling at 10,000 feet gives you some room to try to get things restarted. Stalling at 500 feet is a death sentence.
The Fed needed to cut interest rates at least 8% points (probably 10%) in the early days of this crisis but rates started out way below 8% so that was impossible.
The Fed rate of 0% is actually way too high. To get more borrowing going rates would have to be negtive, where the bank pays you to borrow. That would be very stimulative, but cannot sensibly happen. Interest rates cannot be nominaly negative. (The banks would make no loans whatsoever, and even if they did credit-worthy people would borrow all the money to sit on, just for the profit.)
The correct Fed action in response to this situation has been known for a long time. Krugman published it in 1998 in an analysis of the Japanese deflationary lost-decade. Lots of people got it. Ben Bernanke agreed with that analysis and taught it. (He was a professor at the time.)
The Fed keeps interest rates low today and will continue to have that power tomorrow.
The Fed has to promise to not raise rates in the future as much as they "should," and make people believe it so they will act today based on that promise.
To make sense of an interest rate we have to start by subtracting inflation. If inflation is 6% then a 5.5% loan is a gift. If inflation is at 1% the same 5.5% loan is unattractive.
The Fed cannot cut rates to stimulate today but they can promise to not raise them tomorrow. If reliable, knowing that encourages potential borrowers to take the plunge.
Say the economy picks up a little and we post a quarter or two of 4.5% inflation. Normally the Fed would say the economy is growing again so we are going back to fighting inflation and they would raise rates up from 0%. But they have the option of keeping them at 0%, and with 4.5% inflation that 0% is a bargain and people rush to borrow and invest.
Not to belabor the point, but inflation going up 1% without rates going up is the same as cutting rates 1%.
And if people know that is how the Fed will react to the first signs of inflation then they have a rational expectation of higher future growth, in % terms.
On the other hand, why invest in a weak economy if you think the Fed will decapitate any recovery as soon as it arrives?
(This is why Bernanke was saying in 2010 that the Fed rate would remain at 0% for at least two years. That was not a prediction that recovery was impossible, it was a promise that if recovery came people would be able to cash in on it... so start doing stuff now while the getting is good.)
So that is what the Fed needs to do.
It is not optimal, it is just the only thing they can do regarding rate policy today that would make use the Fed's power to control rates.
Paul Krugman
...What Mike demonstrates is the point that liquidity-trap worriers have been making for a long time – actually, ever since my 1998 piece. Current monetary policy is indeed ineffective in a liquidity trap; but there is still scope for central bank action in the form of credible commitments to keep monetary policy easy in the future, when the economy is no longer at the zero lower bound.
The trouble is how to make those credible commitments. Actually, it’s a two-stage problem. First you have to convince the central bank itself that it’s a good idea to signal that you won’t return to normal policy (say a standard Taylor rule) as soon as the economy lifts off from the liquidity trap; then you have to convince the private sector that the central bank will not, in fact, just revert to type once the crisis is past...
http://krugman.blogs.nytimes.com/2012/09/01/monetary-versus-fiscal-policy-revisited/
= new reply since forum marked as read
