Learning, Deflation, and Interest Rate increases
Mark Thoma reminds me that the basic learning point is covered in his colleague George Evans's European Economic Review (2008) paper with Seppo Honkapohja and Eran Guse:
The unintended steady state, with 0 (or near 0) net interest rate and a deflation rate that satisfies the Fisher equation, is unstable under plausible learning rules -- small deviations of expectations away from this equilibrium will move the system further away, and in particular slightly more pessimistic expectations about future consumption and inflation will lead to a deflationary spiral accompanied by falling output.
The same analysis says that if you happened to be exactly at the 0 net interest rate/deflation steady state, and if the Fed raises interest rates, then that action will push the economy into a deflationary spiral, i.e. deflation will intensify and there will be further downward pressure on consumption and output.
George Evans, Eran Guse and Seppo Honkapohja (2008), "Liquidity Traps, Learning and Stagnation," European Economic Review 52,pp. 1438 – 1463.
