Comment of the Day: "I think the dialogue is very good and Davies makes a good case for low interest rates...:
...but I would add two things:
(1) The straw hawks argument:
If we allow inflation to become embedded in the system, we will then have to raise interest rates abruptly. That is the most likely way that this recovery can end in a severe recession.
is invalid for two reasons. First it is not true that actual and expected inflation greater than 2% would force the FOMC to raise interest rates abruptly. That would be their choice. It is just not true that they must accept a severe recession rather than a few years of inflation over 2%.
Second (as argued by Larry Summers) there is no evidence that the change of interest rates has an effect beyond that predicted given the final level. There is also no particular reason to imagine this is true.
I think there are two problems here. The first is that Fed insiders are grasping at straws -- they feel they have to raise interest rates for political/interest group reasons and so use any argument at hand. Second, I think they talk too much to bond traders.
For a bond trader the level of interest rates matters little compared to sudden shifts in interest rates. For a home buyer or home builder the level not the recent change of the mortgage interest rate matters. here I think a problem is the word 'markets'. The possibility of an abrupt shift in the federal funds rates will alarm 'markets', that is bond traders.
This matters because uh why exactly?
The FOMCs problem (and the reason that outcomes have not necessarily been to the advantage of QE enthusiasts) is that the people who obsessively follow every word they say or write are not the people who determine aggregate demand. The problem is that the traders don't just listen to the Fed: they also talk to the Fed, and Fed insiders listen to them.
Also, economies tend to return to equilibrium after shocks for the same reason that treason shall never prospers. If something lasts, none dare call it disequilibrium.
So the estimated natural rate of unemployment in Spain is 20% and the estimated long term growth potential of Japan suddenly exogenously dropped in the early 90s.
Also, monetary policy is usually used to push economies towards the perceived equilibrium. This doesn't work well at the zero lower bound. Evidence that the Fed pushes US output back towards the trend when this can be done using a low positive federal funds rate is irrelevant. Evidence that the economy returns to normal on its own (even in the USA) is nonexistent. It has only been left on its own when safe short-term interest rates are effectively zero, that is: in the 30s, and since 2008.
All the available relevant evidence suggests that the economy returns to equilibrium very slowly (if at all).