Inflation and Interest Rates

[Kurt_and_Hunter]

When the economy goes bad the Fed seeks to reduce the cost of borrowing money.

This is done by cutting Fed interest rates charged to banks which then (hopefully) flows through the whole system.

Circa 1980 Paul Volker declared war on inflation and raised interest rates like crazy. This intentionally caused the 1981 recession which was designed to wring inflation out of the system. Since the recession was caused by raising rates there was a ton of room to cut rates when the bloody work of inflation fighting was done. During that 10% unemployment recession interest rates were cut something huge. (5%? 6%?)

When our current economy collapsed it was not Fed induced. We were already quite weak (the Bush jobless presidency) and interest rates were already low. So when the wheels started coming off the Fed could only cut rates a little before hitting 0%.

There are models of Fed behavior that suggest that to fix the economy the Fed rate is supposed to be about negative-6%. But in practice it cannot go below 0%.

When you cannot cut rates you can try creating money. The Fed has done plenty of that but it just sits there because the real cost of borrowing is still too high. It doesn't get out into the economy.

Interest Rate - Inflation = Real cost of borrowing money

If you cannot cut interest rates further then there is only one way to reduce the cost of borrowing money. The inflation variable must get bigger.

If the Fed can create some modest inflation (hard to do in our current economy) while keeping interest rates at 0% then that inflation behaves like a few points of interest rate cuts.

And this is why the economists in the wilderness who have been right about everything so far are calling for inflation.

Inflation is usually undesirable... except when the Fed rate is already at 0% and unemployment is pushing 10% and there is no political will for massive stimulus.

(It's like in Ghostbusters when they cross the streams.)

That is a freakish and special case one usually only finds in some kind of depression... but here we are!

_________________

For those who prefer their economics from actual economists (who actually know what they're talking about, unlike me half the time), complete with all those squiggles, here is Krugman's classic paper on inflation expectations in a liquidity trap economy:

http://web.mit.edu/krugman/www/bpea_jp.pdf

[Kurt_and_Hunter]

1. Okay, what loon unrecommended this?

There's not really any opinion in it. It's a fairly dry informational piece.

What am I missing? Is there something objectionable?

Is it wrong? If it's wrong tell me and I'll fix it or amend my thinking in latter posts.

Seriously... what the heck could anyone be rationally objecting to to the degree where they would actually take the trouble to recommend the post?

(It's the Ghostbusters reference, isn't it? The haters hate Ghostbusters...)

[Jackpine Radical]

2. I dunno. I just recced it.

Very interesting. Right or wrong or indeterminate, your piece was edifying and caused me to think about stuff I have no expertise in and generally don't think a whole lot about. Thanks.

[BzaDem]

4. I certainly did not unrec and I agree somewhat higher inflation would be a good thing

to lower real borrowing costs.

But I think a problem is that there is not a huge amount the Fed can do to create inflation. When the Fed creates money, it exchanges the newly created money for short term bonds. In a normal economy, this allows banks to swap long term assets with liquid cash so it can immediately lend the cash.

But in this economy, banks do not want to lend (since the bad economy is lowering the chance that an investment will be paid back). So banks just take the excess reserves they build up, and... buy more bonds. In the end, very little of the money gets lent out. This makes it very hard for the Fed to induce inflation.

What really needs to happen is for the government to spend the money banks are lending it. We need another huge stimulus to increase demand and cause a corresponding rise in prices (or at least ward off deflation). This will also make it easier for banks to make recoverable loans, and therefore increase the effectiveness of the Fed's quantitative easing. Unfortunately, this isn't politically feasible, and absent a stimulus that forces money into the economy, the Fed's cash-bond-cash-bond cycle isn't doing much to cause inflation.

There are potentially a few things the Fed could do, such as swap cash with much longer term bonds. Though long term interest rates are already pretty low. It could also buy bad assets for more than they are worth, though I don't know the legality of this after FinReg (let alone the political ramifications of looking like another TARP).

[Kurt_and_Hunter]

8. Excellent post

I agree that it is very hard to induce inflation in an environment like this.

The Fed target has been 2% for the last couple years and we cannot reach even that minimal target.

It is said (in the Krugman paper linked in the OP and by many others) that the Fed setting the target at 3-4% would do a lot of good by signaling that the Fed would not hike rates until at least 4% inflation. It is thought that that assurance will begin getting money off the sidelines.

You are right that only the stimulative deficit spending our leaders (cough, cough) are currently bad-mouthing is our best bet at getting away from the deflation cliff.

Personally, I would just hand out currency on street corners until some inflation showed up. I am sure folks would prefer less outlandish stimulus, but that's the general idea.

[Barack2theFuture]

3. here we are . . .

our "leaders" doing everything 180-degrees wrong

[nadinbrzezinski]

5. K&R and here we are

I fear Bernacke really don't wanna go there though.

[Kurt_and_Hunter]

11. At least not in his current incarnation > >

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x8907960

[Kurt_and_Hunter]

20. .

[MilesColtrane]

6. The last bout of stagflation ended up giving us eight years of Ronald Reagan.

I don't think that's something we should shoot for.

Modest inflation doesn't hurt so bad as long as there are jobs and wages increase with the CPI. But, juiced inflation with no jobs and stagnant wages is a recipe for working class pain and political disaster.

Besides, the dollar stopped deflating last year. Attempts at shocking the economy back to health have unintended and unforeseeable consequences.

[BzaDem]

7. Stagflation was (to a great extent) cost-push inflation, caused by international supply shocks.

I.e. oil.

This is completely different. Modest demand-pull inflation would be the result of increased demand, which would be a good thing. Right now, the inflation rate is below the Fed's target of 2%. Getting 2-3% inflation would help the economic quite a bit.

[Kurt_and_Hunter]

10. Good post!

[Kurt_and_Hunter]

9. Without inflation we are *guaranteed* no jobs

That's the thing... without inflation the economy can never recover so it's not really optional.

The question is how long we will limp along wrecking lives along the way before doing the inevitable.

And we are good at fighting inflation and terrible at fighting deflation so if we can get a little away from the deflation line at least we will know what we're doing.

[BzaDem]

14. The scary part is that I don't know if we will ever do the inevitable.

I think Republicans might take the House this November, and they will use that to prevent anything that might help the economy in order to make Obama a one term president. If Obama loses (and I still think Obama will win), they will likely also win the Senate in 2012 (due to us having 22 seats to defend versus 9 mostly safe seats for them). Then they will probably kill the filibuster and enact whatever they want (which will not include stimulus). Even assuming Obama wins, it will be really hard for him to get more stimulus through Congress in his second term unless we uncharacteristically pick up massive numbers of seats in 2012.

[hansberrym]

12. Sparking high inflation might be the finishing touch to this debacle.

It would be a neat trick if normal people could borrow money at very low rates interest and pay it back with inflated money. But we know that won't happen. The banks will keep the spread for themselves. If the banks sense that there is inflation, they will raise mortage and other loan rates to avoid losing money. Likewise purchasers of US debt will demand higher rates of return. To avoid chasing its tail, the Fed might be tempted to simply print money w/o issuing new debt, but what effect would that have on current holders of US Debt?

How will the Fed keep this beast under control? Who is to say that inflation won't run away to late 1970's levels or worse?

When our current economy collapsed it was not Fed induced. We were already quite weak (the Bush jobless presidency) and interest rates were already low. So when the wheels started coming off the Fed could only cut rates a little before hitting 0%.

The 2nd and 3rd sentences above suggest that the Fed had kept rates too low for too long prior to the collapse, and thus had a big hand in the collapse. Had the Fed tightened when the housing market began to overheat, the subsequent collapse might have been avoided.

In theory, the Fed's main task is to keep the economy growing steadily by smoothing out the boom/bust cycles. It seems to me that the Fed failed miserably in regards to the housing bubble.

[Kurt_and_Hunter]

19. I agree with much of that, but not all

"The banks will keep the spread for themselves."

They would like to, but for that to happen would require an almost impossible level of collusion.

I have no doubt that banks would do every underhanded thing possible to diminish the benefit to real people but there is a level of real price competition built into the system. Take mortgage rates—they are competitive across a wide range of lenders and show real downward competitive price pressure.

As always, it isn't that these banksters are nice. It is that they are as willing to screw each other as they are to screw anyone else. If there is a dollar in it they will undercut each other.

And auctions (of various types) are such a dominant force in inflation expectation/interest rate world that effective collusion is more difficult than in most realms.

For instance, there is no reason to think that banks are conspiring today to not lend money. There are real-world effects that all banks face that are having similar influences on all banks. Since it was widely predicted in advance that banks would not lend because of economic effects x, y, z I find that a sufficient explanation of why they are, in fact, not lending.

So ordinary people would not benefit 100% but they would surely benefit.

We are in the crumb collecting business. All stimulative action or effect of any sort will benefit the rich disproportionately. If we increase highway building it benefits construction companies. If we increase lending activity it benefits banks. And if we hand out money on street corners it benefits grocery and convenience stores.

[RB TexLa]

13. No thanks I'd prefer my money to have as high a value as possible. I don't care to be

paid back on investments and savings with inflated dollars or euros

[BzaDem]

15. The problem is that if the value remains high, you simply won't be paid back.

When debt deflation kicks in and the real value of people's debt rises, this in combination with people waiting for lower prices will result in your debtor defaulting and going bankrupt. This will cause more bankruptcies and more deflation. You are basically asking for another great depression.

[Statistical]

16. Then you support high deflation.

Your money will be worth more and more and more and more every single day.

Deflation for the win!!!!!!!

Free money for everyone.

[unblock]

17. any inflation policy creates winners and losers. let's see how this one breaks down.

winners: the unemployed; the underwater homeowners; those struggling with exorbitant credit card rates; the federal government and a huge number of state and municipal governments who owe money; and businesses large and small with significant debts outstanding.

losers: people and businesses sitting on piles of cash who insist on continuing to sit on piles of cash and fail to react to the inflation by putting that cash to better use.


sorry there's not one policy that fits all, but it seems to me that overall, a little inflation would be a good thing right now.

[Kurt_and_Hunter]

18. Wow.

Just wow...

Words fail.