Fear of Falling Interest Rates.
The chair of the Fed announced yesterday that interest rates will fall, and soon. So what? Why is low inflation bad for the economy, and why does it present a problem for the Fed’s Governors, particularly the Star Chamber we call the Federal Open Market Committee? Good questions. Keynes once quipped that rapid inflation “armed enterprise against accumulation” by devaluing existing assets and making repayment of loans easier for both entrepreneurs and consumers. In this as in so much else, he was right. How so? The value of existing assets is enhanced by inflation that clocks below the Fed’s target rate of 2% annually. That enhancement dampens demand for credit from entrepreneurs, resulting in lower investment and innovation, presumably slower growth. It also encourages going concerns to stand pat, to hoard their cash, which compounds the prospect of slower growth and thus lowers everyone’s expectations. Meanwhile, debtors, especially consumers, can’t discount their loan obligations, by paying off loans in dollars worth less than they borrowed. Moreover, if inflation is below target, what can cuts in interest rates cause? The real interest rate (adjusted for, uh, inflation) in large swaths of Europe and in japan is now at zero or below. It’s not far from that in the US. What can the Fed do the next time crisis strikes (and it will), if monetary policy is the only arrow in...
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