[lbo-talk] Krugman on interest rate weirdness

[Michael Pollak]

>> Well his argument is that the Fed rate is now 2.25%, but the treasury 
>> rate on both 1 and 3 month notes is a little above 0.5%:
>>
>> http://krugman.blogs.nytimes.com/2008/03/21/weird-interest-rates
>
> So? The plunge to below 1% on the short Treasury rates is very recent. 
> In any case, why should the Fed be unable to push the funds rate down if 
> it's well above market rates? Like I said, they could flood the system 
> with reserves if they wanted. I don't get his reasoning.

His reasoning -- and this is pure speculation on his part which he is the 
first to admit could be done, and he's waiting for someone to point out 
his mistake -- is as follows:

In normal times, all short term rates are basically the same because a one 
day loan of one perfectly safe asset is the same as another.  So the short 
term treasury rate and the fed rate is basically the same.

But recently, they've greatly diverged, which theory (including his:
http://krugman.blogs.nytimes.com/2008/03/22/weird-interest-rates-make-my-life-difficult/
says shouldn't happen.

Now you seem to be implying this is just a momentary piece of noise that 
happens sometimes -- which may be true, and it might be a summary 
counterargument simply to dig up other short term incidents of similar 
size divergences that passed away naturally.

And if that's true, there's no problem.

Krugman is saying: if it's not true -- if this is a structural spread 
between the two rates (based on the perception that bank reserves actually 
aren't as safe as treasuries) -- then no matter how much the Fed floods 
the market, they can't to push the treasury rate below zero.  And if this 
spread persisted, the Fed rate would then be stuck at 1.75%.

His inchoate idea is that in this time of extreme banking stress, the 
relation between the treasury rate and the Fed Funds interbank overnight 
rate might have become something like the relation between the treasury 
rate and the LIBOR, where it's normal for them not to move in lock-step 
because eurodollars deposits are not considered as safe as treasuries, and 
where the the gap between them -- the TED spread -- gets bigger in times 
of trouble and is about this big now.

Michael