Can the Fed set the real interest rate at whatever value it wants? I don't
Do you think they could simultaneously credibly commit to say 10% inflation
and successfully hold the nominal interest rate at zero? Me neither.
What about the simultaneous achievement of 5% expected inflation and a zero
nominal interest rate? Doubtful at best.
What does he mean?
I think he means that if the Fed successfully targets inflation at 10% or 5%, then nominal interest rates will be higher than zero.
I know that Sumner would consider getting nominal interest rates above zero a good thing.
(And, as an aside, Sumner favors returning nominal income to the growth path of the great moderation. My estimate of a target consistent with that growth path for the 4th quarter of 2010 would be about $17 trillion. While that may result in higher expected inflation, the point is to raise real output and employment.)
Getting nominal interest rates above zero is a good thing because of the liquidity trap. If higher expected inflation raises nominal interest rates above zero, then market forces can determine levels of real interest rates that clear markets.
If market forces create an excess supply of credit (or saving greater than investment) at a real rate equal to a zero nominal rate minus the expected inflation rate (usually deflation in this scenario), then the zero nominal bound creates a problem.
That problem is corrected if the expected inflation rate is high enough to get the nominal interest rate high enough that the market clearing real interest rate can be reached.
If prices and wages are perfectly flexible, then real expenditure is always equal to productive capacity, then reductions in real output always reflect decreases in productive capacity.
Either the lower price and wage levels impact the natural interest rate (saving and investment, or the supply and demand for credit as you prefer) or else the price level overshoots (or perhaps one should say, undershoots) creating expected inflation and the market clearing real interest rate.
If prices and wages are not perfectly flexible, then real expenditures can be less than productive capacity and there is demand-constrained production. Production is below capacity until the price level is low enough to raise real expenditures back up to productive capacity.
Raising nominal expenditures fixes that problem. Lower market rates should raise nominal expenditures. But at the zero nominal bound, nominal interest rates can't fall. If it is possible to convince people that prices will rise more rapidly eventually, then even at the zero nominal rate, the implication is a lower real rate. There is presumably some expected inflation rate that is consistent with a market clearing real rate and a zero nominal rate, but if the expected inflation rate is higher than that, the nominal rates rise above zero and real rates still clear markets.
Does Grier believe that prices are always at the proper level so that real expenditures equals productive capacity so that current low levels of real output entirely reflect lower productive capacity? He doesn't say.
Does he believe that the current real interest rates clear markets? That is, the price level now must be at a level so that its expected future rate of of change when subtracted from current nominal rates clear markets? He doesn't say.
As far as I can see, he only seems to be arguing that the Fed cannot keep nominal rates at zero and inflation at 10% or 5%.
So? Is there anyone who considers zero nominal interest rates an end in and of itself?
While I see no value of targeting some high level of inflation, getting nominal interest rates up by shifting expectations is what I think needs to happen.
I favor a target for nominal expenditure--final sales of domestic product--at $16 trillion for the 4th quarter of 2010. This is based upon a modified growth path for nominal expenditure, moving from the planned 2% inflation of the Great Moderation to price level stability. A commitment by the Federal Reserve to expand the quantity of money enough to hit that target will almost certainly cause both nominal and real interest rates to increase at the same time real output and employment grow.