Monday, June 27, 2011

Magic Fed dust

"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."

The accuracy of this quote depends on the definition of the word "hard" (sorry to go all Bill Clinton on you people).

Despite all the recent talk of unconventional monetary policy, the Fed really only has one bullet, manipulating bank reserves. They can shoot that bullet at the nominal interest rate, or at the inflation rate, but not at both.

Suppose the real interest rate required to "produce recovery" was -10%. There is no way the Fed can both hold the nominal rate near zero and create 10% inflation. They might be able to hit -10% fleetingly at a positive and rising nominal rate with a rapidly accelerating inflation rate, but we have seen in the 1970s that such conditions are not conducive to growth.

The Fed simply can't produce stable negative rates on financial instruments relevant for investment or financing consumer durables.

So if "hard" means "impossible to pull off in any sort of constructive way", then I agree with the quote.

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