My jaw drops at all the jaw dropping

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis with a previous life as a prominent economic theorist, made a statement a few days ago that raised a surprising amount of controversy on the blogosphere. He said:

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

This lead a few bloggers to questions his sanity: Employment, Interest and Money (I), Angry Bear (I), Economist's View (I, II, III), Nick Rowe (I, II), and even Paul Krugman (I). Surprisingly, Kocherlakota has few defenders: Steve Williamson (I) and only a few comments in the posts mentioned above.

Kocherlakota is clearly taking about a long run. And if the Fed wants to maintain low nominal interest rates, it can only do so, again this is a steady state, by have a negative inflation rate. This is not only the Fisher equation, but also the result of countless monetary models whose optimal monetary policies are the Friedman rule. In fact it is damn difficult to avoid the Friedman rule even in models with price rigidities. And remember, Kocherlakota was taking about the long run, and in the long run, money in neutral. Not superneutral, though, as the Friedman rule shows.

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