Misery Index, Mark II,
Rolf Englund,
Financial Times 22/6 2006
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Negative real short-term interest rates
The essential fact right now is that
the American economy needs an inflation rate above the Fed’s comfort zone
Paul McCulley, June 2008
Soaring commodity prices, particularly for petroleum and food, are an unambiguous negative real terms of trade shock to America.
For those not familiar with the term, a nation’s terms of trade is the ratio of what it must give up to get what it imports.
Last week, Fed Vice Chairman Don Kohn provided the right answer,
“… an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.”
A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money.