Who Sets Interest Rates?

Paul Krugman argues that lower interest rates are appropriate

The U.S. economy's "potential output" — what it could produce at full employment — has lately been growing at about 3.5 percent per year, thanks to the productivity surge that began in the mid-1990's. But according to the revised figures released a couple of weeks ago, actual growth has fallen short of potential for seven of the last eight quarters.

The conventional view is that we had a brief, shallow recession last year, and that recovery has begun. But the output gap tells a different story: Two years ago we went into an economic funk, and it's not over.

A recent Federal Reserve analysis of Japan's experience declares that the key mistake Japan made in the early 1990's was "not that policy makers did not predict the oncoming deflationary slump — after all, neither did most forecasters — but that they did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy." That's Fedspeak for "if you think deflation is even a possibility, throw money at the economy now and don't worry about overdoing it."

And yet the Fed chose not to cut rates on Tuesday. Why?

Krugman makes an important point, which is that the definition of a recession as negative economic growth is too strict. The economy is underperforming any time output is below potential.

If an interest rate cut by the Fed proves to be unnecessary, it probably will be because the markets are doing the Fed's job for it. As Morgan Stanley's Richard Berner and David Greenlaw point out,

The yield on the 3% 10-year TIP [Treasury security indexed for inflation] that was auctioned a month ago has fallen sharply, by 50 basis points, or roughly the same decline as that in comparable 10-year notes.

What they are saying is that the ten-year real interest rate has fallen from about 3.5 percent to about 3.0 percent, which is nearly a 20 percent decline--during a period in which the Fed supposedly left interest rates unchanged!

Discussion Question. If Fed Chairman Greenspan believes that the interest rate that most affects the economy is the real long-term interest rate, why might he be inclined to see no need to change policy?