‘Neutral’ interest rates and inflation expectations

Caroline Baum:

“'If your model of the inflation process gives weight to inflation expectations as an independent force in creating inflation, which the Fed's does, then you have to pay attention to it, no matter what the quality of the data,' says Neal Soss, chief economist at Credit Suisse Group.

Of course, in targeting inflation, a lagging indicator, 'you run the risk of making a policy error or chasing the markets rather than leading them,' Soss says.”

End of quote.

It’s worth pointing out here that ‘mainstream’ economists refer to inflation as an increase in the general level of prices whereas proper economists refer to it as an expansion in the money supply. Clearly, the former understanding of inflation is used by Soss.

It’s worth quoting Shostak again to aid our understanding of interest rates, sustainable economic growth and inflation:

“In a free market no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium. In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.

The whole idea of the neutral interest rate is unrealistic insofar as we have a Fed that continuously tampers with interest rates and money supply. Given the impossible goal that the Fed tries to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct interest rate.

Sooner rather than later, Bernanke's Fed policy will assume a reactive nature — the US central bank will respond to the data. The fact that the data tends to mirror the effect of past Fed's monetary policies means that the Fed is likely to respond to its own past actions.

The Fed tries to control the future but ends up only chasing its own tail, which leads to more confusion and uncertainty. All this could be further aggravated if Bernanke were to start setting targets for price inflation. As is always the case with centralized monetary planning, attempts to stabilize only bring about more destabilization.”