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Wednesday, November 18, 2015

What the hell is r*? Said every ignorant hedge-fund cokehead ever

BI - this is what happens when you get your Fed commentary from a website of idiots.

I'm not linking to it because of any contribution from Akin Oyedele, because he's just some idiot with a BA in journalism so he shouldn't be expected to make any intelligent contribution whatsoever.

I'm linking to it because the Fed saw fit to include a discussion on the world real interest rate, r*.

What the hell is r*?

Well, it's a theoretical variable that doesn't actually exist in the real world, which forms the basis of things like the Mundell-Fleming open economy model. Basically, it's the theoretical world real interest rate upon which all other interest rates depend.

And the Fed says right in their minutes that they think it's interesting r* has been negative for ages, and doesn't look like it'll ever not be negative again. Quote:

With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies. Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out. Finally, the staff discussed the implications of uncertainty about the level of the equilibrium real rate for using estimates of short-run r* as a guideline for appropriate monetary policy.

This is fucking huge. It means the Fed has finally caught up with reality and are possibly about to change their opinions about very important things. Here's just one of the problems they're now going to be paying attention to:

A lower long-run level of r* would also imply that the gap between the actual level of the federal funds rate and its near-zero effective lower bound would be smaller on average. A smaller gap might increase the frequency of episodes in which policymakers would not be able to reduce the federal funds rate enough to promote a strong economic recovery and rapid return to maximum employment or to maintain price stability in the aftermath of negative shocks to aggregate demand. Some participants noted that it would be prudent to have additional policy tools that could be used in such situations.

I'm going to leave writing any more about this, because I'm only just learning Mundell-Fleming right now, and anyway I still have to polish off my essay. But I can damn well guarantee you that I'll be giving you some links in the next couple days to proper economists who will be explaining just what's so important about the Fed discovering that r* < 0.

In any case, you can be damn fucking sure no hedge fund clown understands the first thing about Mundell-Fleming.

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