Narayana Kocherlakota, the Minneapolis Fed President, gave a speech on August 17th in which he said:

But over the long run, money is, as we economists like to say, neutral…. [I]f 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… [link]

The key point here, is that it sounds like he is saying that a low Fed Funds rate leads to deflation. What’s wrong with that statement? I’ll let Andrew Harless answer that:

It’s true that a low fed funds rate can exist, in long run equilibrium, only if people expect deflation (or if money is worthless). But the causation goes in the opposite direction. People lend at a low interest rate because they expect deflation. People carry umbrellas because they expect rain. An equilibrium with umbrellas must include a significant possibility of rain, but we don’t say that carrying umbrellas must “lead to” rain. If we take away people’s umbrellas, it will not prevent rain, and if we require people to carry umbrellas, it will not cause rain. [link]

Brad Delong and Robert Waldmann have more.

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1 comment for “Deflating

  1. xzz76
    November 28, 2010 at 11:51 pm

    It must be clear that a low interest rate isn’t the cause for deflation…. or else, why do we usually raise the interest rate to prevent inflation?

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