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Inflation is the point

I've been waiting for Paul Krugman to re-explain why we actually want the Fed's QE3 action to result in higher inflation so that i can link to it (because i'm too lazy to try to put it in my own words), and he does today, but actually i think Kevin Drum's version is a little more digestible:

Nonetheless, higher inflation would be good. The simplest way to see this is to look at interest rates. Once the Fed has reduced interest rates to zero, it can't go any further. But what if the economy is so bad that all the standard models suggest you need negative interest rates to get the economy back on track? The only answer is higher inflation. If inflation is running at 2% and interest rates are at zero, the real interest rate is -2%. If you borrow money, you're effectively being allowed to pay back less than you borrowed, which provides a big incentive to buy a house or expand your business.

But if even that's not enough, then how about inflation of 4%? As long as you promise to keep interest rates at zero, the real interest rate is now -4%. The Fed is making it almost irresistable to take out a loan and buy new stuff. And there's a virtuous circle here: businesses understand that negative borrowing rates stimulate consumption and demand, so not only is it super cheap to expand production, but they have good reason to think it will pay off as demand increases in the future.

Both Krugman and Drum note that the problem is that we have such a fear of the concept of inflation that the Fed is unwilling to actually come right out and say that they're targeting higher inflation. We're in a liquidity trap; interest rates are as low as they can go, but it's not low enough to fix our unemployment rate. So we need to do these tricks to get the "real" interest lower. If the economy actually started heating up and inflation actually became a concern, the Fed clearly has a lot of room to raise interest rates to control it.

By fnord12 | September 20, 2012, 12:55 PM | Liberal Outrage