Tuesday, October 18, 2011

The liquidity trap and phantom inflation

It may be instructive to move a few steps back into a discussion of the liquidity trap and the prospects of inflation.  The model we can look at right now is that of the liquidity trap under IS/LM.  From the earlier discussion on the liquidity trap, it is clear that we would expect interest rates to be near zero were a liquidity trap to prevail.  That is exactly what we have:

This is a graph reproduced from the Federal Reserve Economic Data program of the St. Louis Federal Reserve.  It shows that 1-month constant maturity treasuries are currently yielding squat.  Let's just call it approximately zero.  Thinking through the model, when the economy is depressed and monetary policy is largely defanged, would one expect high inflation?

There are many in the political mainstream right that purport to believe that inflation is bound to take off any time now because of the Federal Reserve's easy money policy.  Is there any such sign?

There does not seem to be any indication of high and rising inflation in this graph of the Consumer Price Index.  The rate of change in prices appears to be higher in the period from 2007 to mid-2008 than from 2009 to the present.  Anybody with a model which predicts rising interest rates or rising inflation under current conditions really needs to reevaluate their model.

Is there a sovereign debt crisis in the offing for the United States?  With short-term interest rates at zero and longer-term interest rates slightly higher, there does not seem to be any evidence.  Do these facts suggest that a stimulus would be a fine economic policy right now?  Certainly.  Low interest rates, even long-term, indicate that there is little cost to undertake a serious spending program.  As Paul Krugman has correctly pointed out, the inflation-adjusted interest rates on U.S. treasuries are actually negative, especially for short-term rates, so what's holding policy-makers back from undertaking a large program to bring the economy back to full employment?

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