Saturday, June 12, 2010

Paul Krugman Promotes the Zero Interest Rate Fallacy

Paul Krugman is out today with a seriously incorrect economic observation. Discussing the current interest rate policy, he writes:
When short-term interest rates are up against the zero lower bound...short rates can go up, but not down.
This promotes the idea that the Fed is near the zero bound and that they  can't lower rates any further. It also promotes the idea that the Fed is currently maintaining an easy money policy. Interest rates are very low, but they are not at the zero lower bound and the Fed is conducting a very tight money policy, not the reverse.

The effective Fed Funds rate is at 0.18%, which is much higher than the current 1-month T-Bill rate of 0.015%. Indeed, what should be emphasized at this time is not the zero lower bound but the fact that the rate the Fed can control, the effective Fed funds rate, is much higher than the T-bill rate.

If the Fed wanted to maintain an easy money policy, it would have to drop the effective Fed funds rate below the T-bill rate. Interest rates in terms of high and low are always a relative concept. An effective Fed funds rate of 20% can be "low" and an easy money policy if the real rate (the rate that interest rates would be at without central bank manipulation) is greater than 20%, conversely, an effective Fed funds rate such as 0.18% can be "high", if the real rate is lower. Given that the current 1 month T-bill rate (a proxy for the real rate) is at 0.015%, the effective funds rate at 0.18% is very high.

Thus, it is no surprise that money supply (M2) is not growing.  The Fed would have to lower the effective funds rate considerably (by adding reserves) for the money supply to increase.

For whatever reason, the Fed is conducting a very tight money policy right now, and that's why key indicators are signaling further downside action ahead for the economy, as the economy continues to adjust from the heavy money printing of the Greenspan years and the erratic roller coaster stop-go printing of the early Bernanke years.

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