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Strategies & Market Trends : Mish's Global Economic Trend Analysis
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To: mishedlo who wrote (52637)6/21/2006 9:39:20 AM
From: Perspective  Read Replies (2) of 116555
 
Maybe this is a good time to post some of my thoughts from yesterday. I was trying to figure out just what it was that made so little sense in the inflation targeting at the Fed, and concluded the following.

The trouble with targeting inflation or price levels with interest rates is that interest rates shift both aggregate demand and aggregate supply in the same direction simultaneously. Lower interest rates stimulate demand by increasing debt-based consumption, but they also stimulate supply by encouraging investment. Higher rates stifle demand, but also supply by cutting back on investment in factories and equipment.

Perhaps this is obvious, but for some reason I never see it stated. If one wants to control prices, one needs a lever that shifts one or the other, not both. The real problem with this present system is in guessing which factor of price is going to dominate. I guess you could tie it into Kondratieff here. In the first three K-seasons, debt is low enough that the demand-side pull on pricing dominates. Lower rates result in higher prices and higher rates in lower prices. However, when debt levels become unsustainably high and K-winter takes over, demand becomes relatively inelastic and unresponsive to shifts in interest rates. However, supply still responds via increased investment when rates are lowered. So, lower interest rates no longer support higher prices in K-winter. In fact, they make prices decline by boosting supply in the face of inelastic aggregate demand.

Why am I so alone in seeing this? Shouldn't the PhDs spending their days pondering this stuff have come to this conclusion long ago?

BC
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