Wednesday, July 7, 2010

Step into the shoes of the Federal Reserve

Short-term interest rates are at their all time lows and inflation is not a problem.  Historically low short-term interest rates usually fuel the demand for credit, which usually leads to debt buildup and expansion.  The Fed and other central banks are walking on a very tight rope (although it may not seem like it).  Raise rates and attempt to prevent investors searching for the greatest yield from putting all their money in one place (in effect creating another destabilizing bubble somewhere).  Or put another way: raise rates and brace yourself for deflation, increased bankruptcies, greater liquidity problems, less demand for goods, and higher unemployment.  The popular (and I think correct) thing to advocate is to keep the federal funds rate at the zero bound and handle asset inflation with the Fed's new pistol: regulation.  A pistol as opposed to an M-16 because the first round of regulation legislation seemed less than adequate.  Many observers of the great recession have chosen to blame the Federal Reserve for keeping rates "too low for too long" in the past.  Where are they now? What would they have to say about this? It's easy to criticize the Fed in hindsight but can you blame them right now?  When we do have another bubble on this earth (and we will) and some famous economist claims that this is because the Fed kept rates "too low for too long" we must remember what kind of downside risks our economy is currently facing.  Before we blame the Fed in hindsight, we must remember what the newspapers, literature and economists were preaching at the time. 

For a great source of ideas on this topic Raghu Rajan has got it going on.

1 comment:

  1. The federal reserve is at the center of the problem of income inequality. The devaluation of the dollar over the last fortyfive years or so has been the cause of the rising underclass.