17 Dec 2008

In Fairness to Dr. Krugman…

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…I should correct a slightly unfair post. When a CNBC story reported that the Fed promised to hold rates at low levels for an extended period, I posted that this was exactly what Krugman had called for. Well, not quite. Here is the full context of the actual Fed statement:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

So this isn’t what Krugman (and now Mankiw) want. Here, the Fed is saying, “We will end up keeping rates low because recession will be the big danger, not inflation, for the foreseeable future.”

In contrast to that kind of declaration, what Krugman and Mankiw want is for the Fed to promise future inflation, so that the real interest rate can be pushed lower. This is necessary because the nominal rate has butted up against the 0% wall, and so the only way to provide even more “stimulus” in terms of standard monetary policy is to promise that prices will rise more quickly, making the real costs of borrowing negative. (Note that the last time this happened–see the red line in the chart below–was smack dab in the middle of the housing boom, and then before that it was the late 1970s. Seems like good examples to follow.)

Real Yr/Yr GDP Growth (blue, right)
vs. Real Effective Fed Funds Rate (red, left)

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