Interest Rates and Inflation

Good weekend reading for those who want to go a little deeper into the perils of our economy. First a link to Paul Krugman’s blog at the New York Times: Op-Ed Columnist – Paul Krugman Blog

I want to call your attention to two of his entries:

First is the short piece about ‘Zero Lower Bound Blogging’. The point to be made here is that the economy has sunk into such a slump that the Federal Reserve Board has to abandon its textbook policies and reach onto the odd and peculiar shelf for things to do. Typically the Fed acts to control the economy by using monetary policy. To do this it targets a ‘potential’ level of GDP. Potential GDP is that level of activity consistent with full employment and controlled inflation. When the economy starts to go above this level there is a threat of inflation so the Fed tries to cool it off by raising interest rates. When the economy slows too much below this level the Fed cuts rates in order to limit job losses. The ‘neutral’ level of interest rates from which the Fed would like to start has historically been viewed as 2%. As the chart in Krugman’s blog shows the actual Fed Funds rate and the expected rate [using the rule I just explained] have been remarkably close for the last decade or so. But now the expected interest rate is -6%, which is an absurdity. the conclusion to draw is that normal policies are invalid.

Second: check the chart in the blog entry called ‘The TIPS Spread’. This little chart is equally as depressing. What it tracks is the difference between 10 Year Treasury Interest rates and the rate on similar maturity Inflation Indexed securities. The gap between these two rates is an estimate, by the financial markets, of the inflation rate to be expected over the next few years. As the chart shows the gap has been roughly 2% to 3% over the last six years, but is now zero. The implication is that the Fed has little or no leverage against market expectations of inflation. Remember: the gap measures the difference between nominal [or non inflation adjusted rates] and the inflation adjusted [or ‘real’] rate. Nominal rates are supposed to be higher than the real rates with the difference being inflation. The Fed would like the economy to have a modest inflation rate because that greases the wheels for investment and savings etc.. Having no inflation, or, worse, negative inflation [a.k.a. deflation] is bad news: investment dries up and the economy enters a deep freeze. It becomes the economic equivalent of the living dead. The Japanese experienced this throughout the 1990’s during which time their economy essentially ground to a halt. Japan experienced virtually zero growth for nearly the entire decade.

Take these two fascinating factoids together and we have an ugly possibility rearing its head: are we entering a decade like the Japanese 1990’s?

The only known way to stave that disaster off is massive stimulus. And I mean massive, not just really big. Think $2 trillion over three years rather than the currently proposed $875 over two years.

This is going to be expensive. Get used to it.