Thursday, November 20, 2008

When You Wish Upon a Star...

. Thursday, November 20, 2008

Apropos of my last post, Greg Mankiw doesn't want a pony for Christmas; he wants a unicorn:

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation.
In at least one way, Mankiw is wrong: the credibility of the promise to fight deflation isn't paramount. What is paramount is an assured belief that the Fed actually has the ability to effectively fight deflation. At this point, that proposition look tenuous at best, laughable at worst. And so Mankiw concludes:
That's where the prayer part comes in.
All together now: There's no place like home. There's no place like home.

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