Re: Reengineering the Fed

[Basil Moore <bmoore@xxxxxxxxxxxx>]

Low interest rates are it is true the essence of Keynesian monetary policy.
The CB directly controls the nominal ST rate. Since the inflation rate is
predetermined in the short run, It is also realistic to say that the CB
directly controls the real ST rate.

But the CB cannot directly control the LT rate. On the expectations theory,
LT rates are a weighted average of expected future ST rates, so as to
achieve equal expected holding period returns on assets of diferent
maturity, plus or minus some term premium. It is impossible to refute the
expectations theory empirically, since expected future rates cannot be
measured directly. But the expectations theory is a tautology: it is the
condition for successful holding period arbitrage, just like MR=MC is the
condition for profit maximization. The CB can be viewed as indirectly
attempting to target the nominal and real LT rates, but it will be
successful only if it has sufficient credibility in the capital markets.

Now although targeting a low ST or LT real rate is Good, i.e. Keynesain, it
is not true that the real rate should be held BELOW the LT real growth rate.
The reason is that this situation, if maintained over a period of time, will
lead to rational bubbles.

 The present value of an infinite growing income stream (e.g. land) can be
formulated:

PV = R/(r-g), where r is the discount (interest) rate and g is the growth
rate of real GDP. When the CB keeps  r < g, this causes the discounted value
of land to rise indefinitely.  Land values, and stock values if companies
own land, can then increase indefinitely.

This is the explanation of the Japanese bubble in the late 80's. The Bank Of
Japan lowered long term nominal rates to 2 % , while the grwoth of real GDP
was 5-6 percent, and the inflation rate had been reduced to zero. The value
of Japanese land became indefinitely high, which also pushed up stock values
to 100x earnings.

Such bubbles are dangerous, since if loans are made against such assets as
security, when asset prices later fall, it is as if an atomic bomb went off
in the financial industry. Many FI's become "zombies", with negative net
worth. The Japanese have still not yet cleared away the rubble from the 89
fallout.

 Basil Moore


Basil Moore, Department of Economics
Wesleyan University
685-2363