The fed funds rate *should* be -5%

[Kurt_and_Hunter]

The sheer severity of the slump after the 2008 housing bust means, however, that this normal response falls far short of what’s needed. One way to revive the economy is to consider the so-called Taylor rule, a rule of thumb linking Fed interest rate policy to the levels of unemployment and inflation. Applying the historical Taylor rule right now, with inflation very low and unemployment very high, would mean that the Fed’s main policy rate, the overnight rate at which banks lend reserves to each other, should currently be minus 5 or 6 percent. Obviously, that’s not possible: nobody will lend at a negative interest rate, since you can always hold cash instead. So conventional monetary policy is up against the “zero lower bound”: it can do no more.

http://www.nybooks.com/articles/archives/2010/oct/14/way-out-slump/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+nybooks+%28The+New+York+Review+of+Books%29

The thing to remember there is that to stimulate the economy enough the Fed Funds rate “should” be negative 5%, not at 0%. But it cannot go below zero. (If you directly pay people to borrow money, ie a negative nominal interest rate, then everyone would just borrow the money, pay it back and pocket the profit without doing anything economically useful along the way.)

An effect of this liquidity trap is that interest rates are too high to stimulate the economy. This proposition is counter-intuitive because interest rates are at record lows, so follow along...

We need “loose” money to stimulate the economy. People are not borrowing right now. (Even with the increase in federal borrowing, the total of all borrowing in the US economy is way down.)

When people are not borrowing it is usually because interest rates are too high.

Is a 4.7% mortgage a good deal? Is a 12% mortgage a good deal? Neither question can be answered without knowing the rate of Inflation.

A “record low” mortgage in not a particularly good deal today. The mortgage market isn’t about offering “good deals.” Nobody expects any inflation any time soon. That’s why we can sell ten-year bonds paying well under 3%.

For example, if you borrow $100,000 for 30 years at 5% your total repayment will be around $200,000.

That is double the money you are borrowing, which sounds like a bad deal. What makes it a tolerable deal is that you don’t really pay back $200,000. You get to pay back the loan with devalued dollars… dollars eroded by inflation.

But with 0% inflation you really would be paying $200,000 real money for a $100,000 loan.

So these “record low” mortgages are only attractive if we are going to have some inflation… which there is little sign of.

Now, back to the Fed. We have demonstrated that the Fed’s ability to stimulate with interest rates is too weak. 0% isn’t low enough!

But the real cost of borrowing is (Interest Rate) minus (Inflation). The only way to get the real cost of borrowing down is higher inflation.

Can the Fed create enough inflation to empower them to stimulate the economy? Probably not. They have tried and failed. Japan tried and failed. The Fed can authorize all the loans they want but if nobody will borrow the money (or be lent the money) then it doesn’t get into the economy.

So it all falls to the federal government. The federal government can create inflation by borrowing vast amounts of money and giving it to people who will spend it.

But it will not be allowed to. C'est la vie.

[notesdev]

1. What happens to pensions at that interest rate?

Guess we don't need retirement savings anyway, what with our future work-til-you-die economy.

[Xipe Totec]

2. If we want to encourage people to save, we should not tax interest rate income

let's have one savings account per household that earns tax free interest.

[dkf]

3. We need inflation so wages can increase and that mortgage payment will get smaller in real dollars.

Nice post. Thanks.

[Kurt_and_Hunter]

4. Thank you

:hi: