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Should Interest Rates Be Lower or Higher?

Usually people in the financial industry and financial media rejoice when interest rates rise (Exhibit A), because it means that expected growth rises, which, simply put, means better business. Yet the Federal Reserve tried to lower long-term interest rates with Operation Twist, after they have successfully held down short-term rates at Zero for three years now. Similarly, they now promise to keep short-term rates down at Zero until 2013. In other words, they promise that the economy will stay as it is. I don’t know if that’s a reason to rejoice…

Readers of Scott Sumner’s MoneyIllusion Blog know that our current low rates (especially long-term) signal that cash is scarce and the economy weak. Further, targeting interest rates is an almost prehistoric measure that has long been proven to be less than imperfect. When you target rates, you let growth and inflation do the adjustment part. Should it ever happen that the Fed targets higher interest rates (let’s say, 7% for 10y treasuries), they would induce much larger swings in growth and inflation rates.

Targeting demand, or price level, at least, is a much better option, for you let mainly interest rates do the adjustments, similar to inflation rate targeting.

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