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Goldman Makes The Case Against Inflation

In yesterday's daily research report (not online), Goldman's economists thoroughly debunk the view that the Fed's response to the recession will fuel inflation. Part of the argument is that, as Paul Krugman has pointed out, an increase in the money supply isn't inflationary when banks aren't lending out the extra money. Goldman says that, even before the Fed expanded the money supply (i.e., create extra reserves that the banks could use to increase lending), the banks weren't lending as much as they theoretically could. But if their capacity to lend wasn't a binding constraint, you wouldn't expect them to increase lending just because that capacity increased. And they haven't.

Perhaps more interestingly, Goldman argues that given current forecasts of inflation and unemployment for the next year or so, the Fed, far from easing monetary policy too much, isn't easing enough. Goldman's model of interest-rate setting implies that the Fed should lower the short-term interest rate to an eye-popping -8 percent--that's negative eight--during the next year. But because it's impossible to push interest rates below zero (at least nominal rates), the Fed should be extremely aggressive about easing credit in unconventional ways, like buying securities. Probably even more so than it has been, which is nothing to sneeze at in itself.

Update: I'm in the process of catching up on these Goldman reports and noticed that they've been citing this -8 percent figure for a couple months now. Also, as Zubin pointed out recently (and Goldman notes), the San Francisco Fed has produced a similar number, arguing that short-term rates would ideally be about -5 percent some time next year.

--Noam Scheiber