March 8, 2012

THE LONG SHADOW OF IRRATIONAL EXUBERANCE:

Bernanke Needs Some Bounce in His Tail (Betsey Stevenson and Justin Wolfers Mar 5, 2012, Bloomberg)

Chairman Eeyore is a true dismal scientist, who sees bad news everywhere. He's sure the economy will be in the doldrums for years. Indeed, he's so worried that folks who don't understand his pessimistic outlook will make bad decisions that he gives a speech warning them about it. He says the economy is so weak that he'll need to keep rates low for several years.

Eeyore's message is so sobering that it mutes the desired stimulus effect of the low interest rates. After all, why would you buy anything, or invest in producing it, if you have just learned that some of the smartest forecasters in the country think the economic outlook is so awful that they dare not raise rates until 2014?

Chairman Tigger has a totally different approach. He figures that the prospect of a terrific party will revive everyone's animal spirits. He also knows what folks are thinking: Every time the economy gets going, the 
Fed spoils the party by taking away the punch bowl -- that is, by raising interest rates to keep inflation in check. So Tigger gives a speech promising to keep interest rates low for several years -- even when the economy recovers.

The prospect of low interest rates sustaining a long and robust recovery leads everyone to start spending. After all, good times are just around the corner.

Eeyore and Tigger both did essentially the same thing. They announced that interest rates would be low for several years. But their messages are importantly different, and so yield very different effects.

It might also be helpful if he just explained all the structural forces that limit the prospect of inflation in the long term.
Posted by orrinj at March 8, 2012 6:02 AM
  
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