Plosser misses the point

Charles Plosser, one of the original developers of the Real Business Cycle group of models and Philadelphia Fed President, argues that the Federal Reserve’s recent promise to keep nominal interest rates at (or near)  0 percent until unemployment falls below 6.5 percent or inflation expectations at the 1 -2 year horizon exceed 2.5 percent will impair the process of deleveraging. Here’s what the Fed President had to say;

“Efforts to drive real rates more negative or promises to keep rates low for a long time may have frustrated households’ efforts to rebuild their balance sheets without stimulating aggregate demand or consumption,” said Plosser, who doesn’t vote on monetary policy this year.

This to me seems totally ludicrous and lies at the heart of the problem with the inflation hawk mindset. At the heart of Charles’ argument is that as interest rates decrease, the rate on savings becomes less and so the incentive to save today diminishes (at least this is what I presume he is getting at), whilst the return on whatever savings they do have decreases and thus reduces the amount of money they have available to pay debts off. However this whole thought process seems to neglect the fact that if an individual is net indebted, his or her net interest earnings are in fact negative i.e. they are paying more interest out on their borrowings then they are earning on their savings,  even if the actual interest rate they pay on each is identical. Thus for such debtors, any decrease in real interest rates is exactly what is needed at the margin.

Secondly, we haven’t even talked about one of the most important, yet one of the most neglected, issues in modern macroeconomics – the idea of debt deflation.  This is the notion first proposed by Irving Fisher (and recently rejuvenated by Gauti Eggertsson and Paul Krugman) that dramatic recessions are often propagated by falling prices, combined with indebted households whose debts are fixed in nominal value, so that the real value of those debts in fact increase as prices fall further.  As these households fight against the tide and cut their spending even further to pay off the increased real value of their debts, prices fall further and the process continues, leading to a greater and greater general contraction.

Now I’m not suggesting that we have as severe a problem with debt deflation today (since inflation in the US is approximately 1.8 percent) as Irving Fisher was confronted with when he cane up with the theory in response to the Great Depression. But when households are attempting to reduce the real value of their outstanding debts, a little extra inflation is certainly a good thing in helping them achieve this.

Also, whilst their may not be such a chronic case of deflation as there was some 80 years ago following the Depression, households have certainly experienced a real increase in the value of their outstanding debts. As nominal incomes have moved to a permanently lower (trend) level – see graph below and David Beckworth’s post for a more in-depth discussion – the nominal value of their outstanding debts remained the same and so the real value of their debts increased.

US Nominla GDP1

All in all, I just don’t see how falling rates of interest will lead to increasing household debts as Charles Plosser suggests.