Interest rates still aren’t plebeian enough to stimulate the U.S. economy. Washington needs to engender additional inflation so "real" rates turn substantially negative

By Peter Coy

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Can an participation rate of zero be too high? Unfortunately, yes. A new analysis through the agency of Goldman Sachs (GS) concludes that the Federal Reserve’s cut in the treaty funds duty to a record low of zero to 0.25% on Dec. 16 isn’t going to be nearly enough to get the economy going afresh. The state says the Fed would need to subject the federal funds degree to negative 6% by the expiration of 2010 to supply the needed amount of monetary stimulus.

The problem: It’s literally unthinkable to cut interest rates below nothing. As a result, "we are entering a nature with touch rates that are far too southerly for the economy’s good," Goldman Chief U.S. Economist Jan Hatzius wrote in a Jan. 16 research note.

That’s a bombastic negative towards a U.S. economy that’s already in a deep slump, by retail sales, industrial production, and exports total plummeting. Citigroup (C), Bank of America (BAC), General Motors (GM), and Chrysler, in the midst of others, are struggling to keep their heads above water. Circuit City, the second-biggest U.S. electronics retailer, announced on Jan. 16 that it was going out of business and closing all its stores through the end of March. Meanwhile, homebuilders like Lennar (LEN) and D.R. Horton (DHI) are getting squeezed through a record decline in home prices.

Ordinarily at the time that the economy slows, the Federal Reserve have power to juice it up by cutting short-term interest rates to below the rate of inflation, meaning that in inflation-adjusted terms, rates are actually negative. For example, suppose that inflation is running at 6% per year and interest rates are at 4%, the "real" rate is negative 2%. Negative real rates entice people to borrow wealth for extinction or investment, which gets the good housewifery going again and soaks up unemployed workers and equipment.

Right now, zero is about right for interest rates. But the administration is continuing to soften, so it will soon exist too high, according to Goldman. Hatzius bases his calculation on Goldman’s own version of the so-called Taylor Rule, which is named after Stanford University economist John Taylor. Taylor says the Fed needs to rely against the wind by raising rates when the economy is overheating and clouded them when there’s a lot of lingering.

Trouble is, the Federal Reserve have power to’t cut interest rates beneath the rate of blowing up grant that swelling falls to zero, that many economists expect to happen soon. Clearly the Fed can’t take in $1,000 and pay back only, say, $950 a year later. Rational investors would simply keep their coin in cash outside the banking system to preserve its value.

The solution is obvious: The Fed needs to deliberately amplify the rate of inflation—maybe not all the way to 6%, but significantly above nothing.

One scheme to grant that is to print lots of money. The Fed can create money from thin air by purchasing assets such as Treasuries and mortgage-backed securities and paying for them by crediting the seller with newly created reserves at the central bank.

That way today’s zero interest rates would be negative in inflation-adjusted terms and the regulation would increase the boost it indispensably. Fed rate-setters would need to swallow hard, since 99.99% of the era they try to quell inflation, not raise it. But most of the voters on the Federal Open Market Committee are aware that deflation can be each even greater nemesis than inflation.

Even generating negative real rates won’t be sufficiency to turn the economy encircling. So the government will also need to strengthen the banking system and give the economy a fiscal motive by cutting taxes and increasing body politic spending, as the Obama Administration proposes to do. To rescue the banks, Hatzius favors more purchases of depressing assets that are on banks’ balance sheets as far in the same proportion that lending by the Fed against consumer asset-backed securities.

Princeton University economist Paul Krugman favorably cited Hatzius’ research in his New York Times blog on Jan. 17. No surprise there, since Krugman himself pinpointed a similar problem in Japan for the time of its "lost decade" of slow economic growth in the 1990s. Wrote Krugman: "This is why we need a colossal financial provocation, unconventional monetary policy, and anything otherwise you can think of to fight this fall through. Quite literally, the usual rules no longer apply."