The Everyday Economist

Bloomberg reports:

Traders predict the Federal Open Market Committee, meeting today in Washington, will lower the overnight lending rate by a full percentage point, based on futures prices in Chicago. That would be the biggest reduction since 1984, when Paul Volcker led the central bank, and would bring the benchmark rate down to 2 percent.

Yeesh.

UPDATE: Robert Murphy and Lee Hoskins plead for a stop to the rate cuts:

The Fed has abandoned the one thing it can truly control–the long-run increase in price levels–in a self-defeating attempt to keep the economy growing. A good portion of the housing mess itself is the result of Fed policy: In response to the 2000-2001 recession, chairman Alan Greenspan brought the federal funds rate down to a shocking 1% by June 2003, then held it there for a full year. The rate was then steadily ratcheted back up, reaching 5.25% by June 2006.

These actions first helped inflate the home-price bubble and then helped burst it. Naturally, there are many factors–and perhaps even villains–that helped create the housing bubble, but excessively low interest rates were surely a necessary ingredient.

Regardless of past mistakes, the Fed must now make the best of a bad situation. It must stop chasing the financial markets, and even the broader economy. Creating more dollar bills will not add to the nation’s wealth, or make workers more productive.

Indeed.

Our friend jk over at Three Sources laments:

While I’m willing to defend all the Fed’s actions to date as protection from deflationary shocks, I’ll join Mr. Kudlow in suggesting no further cuts.

Not to pick on jk (as it is not clear from the post whether he fears deflation from world economic growth, excess demand for money, or both), but deflation gets a bad rap — as it should in some cases. Deflation, however, is not all bad. Rather it depends on the cause of deflation.

There is a stark difference between what we will call benign and malign deflation*. Benign is deflation that is caused by an increase in growth. Malign deflation on the other hand is that which is caused by an excess demand for money. In order to understand the difference, recall the equation of exchange:

MV = Py

where M is money, V is velocity, P is the price level, and y is real output. A productivity increase will lead to an increase and y and a decrease in P (for simplicity, we will assume that the changes are equal). The decrease in the price level is quite “natural” to economic growth as the change is not due to some monetary disturbance, but rather an increase in productivity. Additionally, real incomes rise without nominal wage adjustments. This is known as benign deflation and is perfectly healthy (and perhaps desirable) in a growing economy.

By contrast, consider a change in money demand (where money is understood as money holdings). In this case, people will tend to hold more money, which decreases velocity (V). If the central bank does not respond with a corresponding increase in money (M), the pressure falls on the right-hand side of the equation. Thus, there is downward pressure on nominal output (Py). This is known as malign deflation and is necessarily harmful to the economy. As individuals hold more money, they are forgoing potential purchases. This puts downward pressure on the price level. However, prices are sticky and therefore do not fall simultaneously, but rather they fall sequentially. Thus, the downward pressure on prices results in downward pressure on output in sectors where prices are relatively sticky. The result is a reduction in real output as well as a fall in the price level.

As should be obvious, the differences are stark. When deflation results as a consequence of economic growth, this fall in the price level is quite desirable. However, when deflation results due to a monetary shock or central bank mismanagement, the results can be quite startling.

This difference was recently traced by David Beckworth, who finds that in the postbellum United States, there is ample evidence of a difference between benign and malign deflation.

So fear not deflation — as long as it is the result of economic growth.

* This terminology is consistent with that used by Beckworth (2007) and others.

Paul Krugman writes:

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression.

Of course, the evidence is quite to the contrary.

Larry White says “no.”

UPDATE: Tyler Cowen agrees that the gold standard isn’t a ‘crazy’ idea, but nevertheless rejects a return to commodity-backed currency. Meanwhile, a commenter on the post at MR writes:

The purchasing power of gold has varied over a factor of ten since the 70s. Hardly a standard of value.

This is a very misleading statement. Since the 1970s, gold has been de-monetized. As Larry White explains, under the gold standard, the demand for gold is largely transactions-based and therefore the fluctuations in its purchasing power remain quite stable. When gold is de-monetized, however, its purchasing power tends to fluctuate a great deal.

UPDATE II: Larry White responds to Tyler Cowen.

Steve Horwitz echoes my thoughts (expressed in a post yesterday):

…excessive supplies of credit enabled mortgage lenders to give out high loan-to-value mortgages right and left, leading to delinquencies and foreclosures, supposedly leading to a weakening economy and a falling stock market, which the Fed is now attempting to “cure” by cutting rates by 75 basis points, which will inject even more funds into the economy.

In response to Ben Bernanke’s comments that inflation expectations are “reasonably well anchored” Larry White responds:

Translation: Even though the Fed’s preferred measure of inflation, the Personal Consumption Expenditure deflator, is currently running at 2.2% year-over-year, above the Fed’s “comfort zone” (in which 2% inflation = price stability), TRUST US, the inflation rate will come down in 2008 even though we will be accelerating money growth with a big Fed Funds target rate cut at our next meeting, the opposite of pursuing an anti-inflation policy.

The Fed is proceeding down a dangerous path. We are experiencing quite a dichotomy with inflation above the Fed’s comfort zone and the economy experiencing a great deal of friction in the housing and credit markets (which are slowing spreading outward). Loose Fed policy encouraged this mess and now the Fed is seeking to remedy the problem with more liquidity. Yeesh!

Paul Krugman wonders:

So: is it even possible for the Fed to cut interest rates enough to create a renewed housing boom? (The Fed can cut the overnight rate all the way to zero, but even large changes in the overnight rate can have only modest effects on mortgage interest rates, if the market perceives those changes as temporary.) If it can’t, how much can the Fed really do to help the economy?

Those aren’t rhetorical questions. I’m actually not sure how bad things will get — remember, we still have help from booming exports. But it’s not too hard to tell stories in which monetary policy doesn’t have enough mojo to deal with our current problems.

There has been a lot of talk about monetary policy given the ongoing collapse of the housing market and the candidacy of Rep. Ron Paul. Thus I thought that I would outline my views on monetary theory and policy:

1.) The quantity theory of money summarizes the long-run relationship between money and inflation.

2.) Economic growth (in line with the quantity theory) is deflationary.

3.) Short-term fluctuations in the economy are largely caused by monetary disturbances.

4.) Too much emphasis is placed on the overall price level in the short-run. We should be more focused on relative prices.

5.) I do not trust discretionary monetary policy. The Fed should operate by using a monetary policy rule, a money growth rate target, or an inflation target.

6.) The focus of monetary theory should be on credit markets because it is directly through these markets that monetary policy is conducted.

I suspect that I may get some disagreement on 2, 4, and perhaps 5. It is my opinion that number 6 and number 4 represent the future of monetary theory.

John Taylor looks at housing and monetary policy:

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

Here is a non-gated version of the paper.

– Ben Bernanke promises a more transparent Fed.

– American Gangster’s Wad of Euros Signals U.S. Decline, Bloomberg

– James Hamilton on oil, gold, and inflation.