"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."The above is from the President of the Federal Reserve Bank of Minneapolis, a member of the Federal Open Market Committee that sets monetary policy (link below). The statement is appalling on many levels. To me, it indicates that at least one member of the Fed has simply gone down the rabbit hole with their logic, or is letting their politics determine policy. I'm not sure which interpretation is scarier.
Remember in the early l980's when the Fed (led by Volker) raised interest rates to fight inflation? It was painful (mortgage rates above 10%) but effective. By raising interest rates the Fed choked off the perception that one could make money by betting on inflation. We now have one of the members of the Fed arguing that to fight deflation we also have to raise interest rates - how is that supposed to work? One policy does everything?
Let's look at his argument a little closer. Mr. Kocherlakota is, in effect, arguing that low interest rates lead to a perception of deflation, which then encourages more deflation. Thus, there is a need to raise interest rates in the face of deflation so that people think that the Fed expects inflation and then, obviously, people will act as if deflation is over. He thinks companies that won't borrow money and expand when interest rates are extremely low will somehow decide to borrow and expand when interest rates are raised.
Some background: recall that inflation is caused by too much money chasing too few goods, which leads to an upward pressure on consumer prices, demands for increased wages, leading to more money available to buy goods - a classic positive feedback loop. High interest rates may break this cycle by reducing the amount of money chasing the available goods. There is no doubt that increasing interest rates is a psychological shock to the business community - but it also has an understandable, rational mechanism by which it breaks the inflationary cycle. No voodoo economics required.
Conversely, deflation is caused by too little money chasing too many goods. In a deflationary economy, companies aren't selling their products, so they cut workers and pay while trying to keep a high level of productivity. The the result is the amount of money available to buy products falls faster than then number of products available - again a classic positive feedback loop. So how can high interest rates break this loop? If businesses find the cost of capital greater why are they going to hire more workers? How does raising interest rates change the problem of too little money chasing too many goods? It seems to me that Mr. Kocherlakota is arguing that rational mechanisms are unimportant and the Fed only has to fool business into expecting inflation to break a deflationary spiral. The emperor just has to make people believe and he can parade around naked.
If our banking community has become this divorced from reality and logic, we are in for a long and painful ride.
Note: the above ideas were the result of my trying to follow a fairly obscure post of Paul Krugman
http://krugman.blogs.nytimes.com/2010/08/29/i-am-a-psychotic-ferret/ that points to an economic wonk's web site
Link to the text of Mr. Kocherlakota speech: