Krugman’s blog, 8/25/15

There were two posts yesterday.  The first was “It’s Getting Tighter:”

When thinking about the market madness and its possible real effects, here’s something you — where by “you” I mean the Fed in particular — really, really need to keep in mind: the markets have already, in effect, tightened monetary conditions quite a lot.

First of all, if break-evens (the difference between interest rates on ordinary bonds and inflation-protected bonds) are any guide, inflation expectations have fallen sharply:

Second, while interest rates on Treasuries are down, rates on private securities viewed as even moderately risky are up quite a lot:

So real borrowing costs are up sharply for many private borrowers. This is a significant headwind for the U.S. economy, which was hardly growing like gangbusters in any case.

A Fed hike now looks like an even worse idea than it did a few days ago.

Yesterday’s second post was “Unnatural Obsessions:”

One enduring constant of the world economy since 2008 is the chorus of sober-sounding people declaring that the Fed must act responsibly and raise rates. A few years back, rising commodity prices and a flood of money into emerging markets were proof that low rates were dangerously inflationary and must be hiked. Now we have plunging commodity prices and a flood of money out of emerging markets; clearly, this shows that the Fed must do the right thing, and raise rates.

The underlying claim in all such demands is that the low interest rates we’ve had since 2008 are “unnatural” or “artificial”. So it’s probably worth repeating that while very low rates may seem strange, they also seem fully justified by the economic situation. The original Wicksellian concept of the natural rate of interest defined that rate as the rate consistent with stable prices, with an economy that was neither too hot nor too cold. If we had had an unnaturally low rate these past 7 years, we should have seen accelerating inflation; we haven’t.

Quantitative easing, by the way, is just more of the same. If you are claiming that the Fed has created artificially easy credit, you have to explain how it can do that year after year without producing inflation or an overheating economy. Nobody has ever produced a coherent story about how Fed policy can drive interest rates below their natural level without inflationary effects.

So even if you believe that a low-rate environment is helping to feed a series of bubbles, you have to ask how it can possibly make sense to raise rates when the underlying problem is overall economic weakness, which a rate hike would make worse.

One last point: many people have noted the resemblances between current events and the market instability of 1998. However, few have pointed out that the volatility of 1998 followed a long period in which long-term interest rates never dropped below 5 percent. Hot money doesn’t need ultra-low rates to be subject to enthusiasms and sudden losses of confidence.

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