Are you Smarter than a Fed President?

[Kurt_and_Hunter]

Nick Rowe, Brad De Long, Krugman, etc. have been teeing off for days on comments by Narayana Kocherlakota, President of the Minneapolis Fed. Kocherlakota is part of the "raise rates in a near depression" Fed cohort. Here's what the rhubarb is about...

But over the long run, money is, as we economists like to say, neutral.... If the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent... a low fed funds rate must lead to consistent—but low—levels of deflation.... If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation...

http://www.minneapolisfed.org/news_events/pres/speech_display.cfm?id=4525

http://krugman.blogs.nytimes.com/2010/08/29/i-am-a-psychotic-ferret/

Two questions.

1) Is he saying that low interest rates lead to deflation?

2) Is that a correct statement?

[ixion]

1. He is living in a fantasy world

so he's not really saying anything meaningful, therefore there's nothing to be "correct" about.

[Kurt_and_Hunter]

2. I don't like to bias the poll unduly in the OP:

He seems to be saying that a fed funds rate of .25% is consistent with deflation and that if the fed funds rate is out of line with "real" value then the real world must change to close the gap with the fed funds rate.

So if the fed funds rate is unrealistically low people will react to money being on sale at the Fed by borrowing less because only by refusing to borrow at a too-low rate could economic actors restore sanity to the fed funds rate.

Cause that what drives individual business decisions... "Gee... I wonder if my action will be consistent with a hypothetical world where the current fed funds rate would be correct."

The low fed funds rate is supposed to cause economic actors to be more active. That is why it is so low... to try to get people to start more businesses, buy more houses, etc..

(Worst of all, the fed funds rate at .25% is not really a low rate in today's world. How do we know this? Because if it was not for the inconvenience of not being able to go below zero the fed would have kept cutting rates during this crisis and the fed funds rate would be something like -4%.)